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Accounting Ratios

Accounting ratio is mathematical representations of two or more data either interrelated or independent to analyze the financial condition of any business. Accounting ratios are determined using accounting information collected from the financial statements.

Accounting Ratios are also known as Financial Ratios as these ratios help in determining the financial performance of the business.

Different ways to show Accounting Ratios

Four different ways to show financial ratios are;

  • Simple or Pure form – A simple form are those that are represented in the quotient form for instance– 2:1
  • Percentage – A Percentage form are those that are represented in the percentage form for instance– 50%
  • Turnover Rate or Times – A Turnover Rate and Times form are those that are represented in the rate or times form for instance– 5 Times
  • Fraction – A fraction form are those that are represented in the fraction or decimal form for instance– 1/3 or 1.33

Types of Accounting Ratios

  1.  Liquidity Ratio
  2.  Solvency Ratio
  3.  Profitability Ratio
  4.  Activity Ratio

1. Liquidity Ratio

Liquidity ratio determines the paying capacity of a business to meet short-term liabilities. A business having a liquid ratio of 2 or more is considered ideal. Here is the list of Liquidity Ratio:

Ratio Name

Usage

Formula

Current Ratio
  1. This the most commonly used liquidity ratio that helps a business in comparing their current assets with their current liabilities
  2. Current ratio helps a business to analyze whether they will be able to pay their due debts in the next twelve months or not
  

Current Assets ÷ Current Liabilities

Quick Ratio
  1. The quick ratio is like current ration except quick assets are compared with current liabilities.
  2. The other name of Quick Ratio is Acid test Ratio

Quick Assets ÷ Current Liabilities

Cash Ratio
  1. This ratio takes those current assets into the account that is instantly accessible to a business to meets its debts.
  2. Any business having a Cash Ratio of one or more is considered financially stable.

(Cash + Marketable securities ) ÷ Current Liabilities

 

2. Solvency Ratio

Leverage ratio helps a business to determine its long term solvency. Generally, these ratios are used to analyze the debt paying capacity of the company. Here is a list of most commonly used solvency ratios:

Ratio Name

Usage

Formula

Debt to Equity Ratio
  1. Debt Equity Ratio helps a business to analyze the relationship between total debt and shareholders fund.
  2. This ratio shows the commitment of both creditors of the company and the company’s shareholders.

Total Debt ÷ Total Equity

Debt to Asset Ratio
  1. Debt to Asset ratio helps a business to determine how many total assets are financed by the creditors.
  2. Less than 1 debt to asset ratio indicates that assets can be further financed and vice-versa

Total Debt ÷ Total Asset

Proprietary Ratio
  1. The proprietary ratio shows a relationship between Proprietor’s fund/shareholder’s funds with total assets of a business.
  2. This ratio helps in determining the financial strength of a business.

Proprietor’s fund/shareholder’s funds ÷ Total Asset

Fixed Asset Ratio
  1. Fixed Asset Ratio helps a business to understand the relationship between fixed assets of business with long term debts.
  2. This ratio indicates a business capacity to discharge its liabilities and ensures long term survival.

Net Fixed Assets ÷ Long term debt

Interest Coverage Ratio
  1. Interest coverage ratio determines the relationship between the Earnings before interests and taxes with interest on long term debts
  2. Higher the interest coverage ratios lower the risk of financial default.

Earnings before interest and taxes (EBIT) ÷ Interest on long term debts


3. Profitability Ratio

Profitability ratio helps in analyzing how much profit is earned by a business from its operations. In other words, Profitability Ratio determines the earning capacity of a business using through the resources employed. Here is a list of profitability ratios that are normally used:

Ratio Name

Usage

Formula

Gross Profit Margin
  1. Through Gross Profit ratio any business can compare its performance with its competitors or its own previous performance
  2. Gross Profit ratio defines the percentage of factory cost in relation to the sales amount
  3. Higher gross profit margin indicates that business is more efficient in its operation.

Gross Profit ÷ Revenue

Operating Margin
  1. Using Operating Margin ratio any can easily measure how much amount is earned through operating income
  2. The other name of Operating Margin Ratio is Operating Profit Margin

Operating Income ÷ Net Sales

Profit Margin
  1. Through Profit Margin ratio any business can determine the amount of profit earned from its total generated revenue
  2. A business can easily assess its overall profitability to compare it with its competitors

Net Income ÷ Net Sales

Earnings per Share (EPS)
  1. EPS is a business profit portion allotted to every share indicating its profitability
  2. EPS helps the shareholder to determine their return on investment

(Net Income – Preferred Dividend) ÷ Common Outstanding Shares

 

4. Activity Ratio / Efficiency Ratio

Activity ratio shows the revenue generated from a particular asset type by comparing cost, sales and asset data. This ratio helps the business inefficient management and effective utilization of the assets. Here is the list of Activity ratio that is used normally:

Ratio Name

Usage

Formula

Stock Turnover Ratio
  1. Stock turnover ratio helps a business to understand the relationship between Inventory and COGS.
  2. Through stock turnover ratio makes the stock reordering task easy and business comes to know its stock conversion rate.

COGS ÷ Average Stock/Inventory

Debtor Turnover Ratio
  1. Debtor turnover ratio helps a business to determine the relationship between net credit sales and average debtors or bills receivables.
  2. A company having higher debtor turnover ratio indicates an effective credit strategy.

Net credit sales ÷ Average debtors or bills receivables

Creditors Turnover Ratio
  1. Creditors Turnover ratio provides an understanding regarding the relation between net credit purchase and average creditors or bills payable.
  2. Generally, a higher ratio indicates efficient asset utilization and management by the business.

Net credit purchase ÷ Average Creditors or Bills payable

Working Capital Turnover Ratio
  1. Working Capital Turnover Ratio helps in determining the relationship between net sales and working capital.
  2. A higher ratio of Working Capital Turnover indicates efficient use of working capital.

Sales or COGS ÷ Working Capital

 

The Bottom Line

Accounting ratios may help you to analyze the performance of business but on the contrary, they are calculated at a specific time and date. Hence, it is important to do an in-depth evaluation instead of completely relying on the accounting ratios.

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