What are Accounting Ratios?

There are four main types of accounting ratios: –

  • Liquidity RatioProfitability RatioProfitability RatioProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.read moreLeverage RatioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.read moreActivity Ratios Activity RatiosActivity Ratios measure the organizational efficiency to utilize its various operating assets (as shown in the balance sheet) to generate sales or cash. It includes inventory turnover ratio, total assets turnover ratio, fixed asset turnover ratio and accounts receivable turnover ratio.read more

Let us discuss each of these in detail –

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Types of Accounting Ratios with Formulas

There are four types of accounting ratios with formulas: –

#1 – Liquidity Ratios

This first accounting ratio formula is used to ascertain the company’s liquidity position. It is used to determine its paying capacity towards its short-term liabilities. A high liquidity ratio indicates that the company’s cash position is good. A liquidity ratio of two or more is acceptable.

The current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities read more compares the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more to the current liabilities of the businessCurrent Liabilities Of The BusinessCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read more. This ratio indicates whether the company can settle its short-term liabilities.

Current Ratio = Current Assets / Current Liabilities

Current assets include cash, inventory, trade receivablesTrade ReceivablesTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet.read more, other current assets, etc. Current liabilities include trade payables and other current liabilities.

Example

ABC Corp. has the following assets and liabilities on its balance sheet.

Current Assets = Short-term Capital + Debtors + Stock + Cash and Bank = $10,000 + $95,000 + $50,000 + $15,000 =$170,000.

Current Liabilities = Debentures + Trade Payables + Bank Overdraft = $50,000 + $40,000 +$40,000 = $130,000.

Current Ratio = $170,000/ $130,000 = 1.3

The quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities.read more is the same as the current ratio, except it considers only quick assets that are easy to liquidate. It is also called an acid test ratioAcid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.read more.

Quick Ratio = Quick Assets / Current Liabilities

Quick assets exclude inventory and prepaid expensesPrepaid ExpensesPrepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period.read more.

The cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more considers only those current assets immediately available for liquidity. Therefore, the cash ratio is ideal if it is one or more.

Cash Ratio = (Cash + Marketable SecuritiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company’s balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more) / Current Liabilities

#2 – Profitability Ratios

This accounting ratio formula indicates the company’s efficiency in generating profits. It shows the earning capacity of the business in correspondence to the capital employed.

The gross profit ratio compares the gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more to the company’s net sales. It indicates the margin earned by the business before its operational expenses. It is represented as a percentage of sales. The higher the gross profit ratio, the more profitable the company is.

Gross Profit Ratio = (Gross Profits/ Net revenueNet RevenueNet revenue refers to a company’s sales realization acquired after deducting all the directly related selling expenses such as discount, return and other such costs from the gross sales revenue it generated.read more from Operations) X 100

Net Revenue from Operations = Net Sales (i.e.) Sales (-) Sales Returns

Gross Profit = Net Sales – Cost of Goods Sold

The cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more includes raw materials, labor cost, and other direct expenses.

Zinc Trading Corp. has gross sales of $100,000, sales return of $10,000, and the cost of goods sold of $80,000.

Net sales = $100,000 – $10,000 = $90,00

Gross Profit = $90,000 – $80,000 = $10,000

Gross Profit Ratio = $10,000/ $90,000 = 11.11%

The operating ratio expresses the relationship between operating costs and net salesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company’s gross sales.read more. It is used to check the efficiency of the business and its profitability.

Operating Ratio = ((Cost of Goods Sold + Operating Expenses)/ Net Revenue from Operations) X 100

Operating expenses include administrative expenses, selling, and distribution expenses, salary costs, etc.

The net profit ratio shows the overall profitability available for the owners as it considers both the operating and non-operating income and expenses. Higher the ratio, the more returns for the owners. It is an important ratio for investors and financiers.

Net Profit Ratio = (Net Profits After Tax / Net Revenue) X 100

ROCEROCEReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.read more shows the company’s efficiency concerning generating profits compared to the funds invested in the business. It indicates whether the funds are utilized efficiently.

Return on capital employedCapital EmployedCapital employed indicates the company’s investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. “Capital Employed = Total Assets - Current Liabilities” or “Capital Employed = Non-Current Assets + Working Capital.“read more = (Profits Before Interest and Taxes / Capital Employed) X 100

R&M Inc. had profits before interest and taxes of $10,000, total assets of $1,000,000, and liabilities of $600,000.

Capital employed = $1,000,000 – $600,000 = $400,000.

Return On Capital Employed = $10,000/ $400,000 = 2.5%.

Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more show the company’s revenues concerning one share. It is helpful to investors for decision-making about the purchasing/ sale of shares as it determines the return on investment. It also acts as an indicator of dividend declaration or bonus issuesBonus IssuesBonus shares refer to the stocks issued by the companies for free of cost to their existing shareholders in the proportion of their stock holdings. Companies issue such shares to compensate the shareholders with a higher dividend payout in the form of stocks.read more shares. If earnings per share are high, the company’s stock price will be increased.

Earnings Per Share = Profit Available to Equity Shareholders / Weighted Average Outstanding Shares

#3 – Leverage Ratios

These accounting ratios are known as solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business.read more. That is because it determines its ability to pay for its debts. Investors are interested in this ratio as it helps determine how solvent the company is to meet its dues.

It shows the relationship between total debts and the company’s total equity. It is useful to measure the leverage of the company. A low ratio indicates that the company is financially secure; a high ratio suggests it is at risk as it is more dependent on debts for its operations. It is also known as the gearing ratio. The ratio should be a maximum of 2:1.

Debt-to-Equity Ratio = Total Debts / Total Equity

INC Corp. has total debts of $10,000, and its total equity is $7,000.

Debt-to-Equity ratio = $10,000/ $7,000 = 1.4:1

The Debt Ratio Debt RatioThe debt ratio is the division of total debt liabilities to the company’s total assets. It represents a company’s ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assetsread more measures the liabilities in comparison to the assets of the company. A high ratio indicates that the company may face solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more issues.

Debt Ratio = Total Liabilities/ Total Assets

It shows the relationship between total assets and shareholders’ funds. It indicates how much of shareholders’ funds are invested in the assets.

Proprietary Ratio = Shareholders Funds / Total Assets

The Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company’s current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company’s liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more measures its ability to meet its interest payment obligation. A higher ratio indicates that the company earns enough to cover its interest expense.

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense

Duo Inc. has earnings before interest and taxes of $1,000, and it has issued debentures worth $10,000 @ 6%.

Interest expense = $10,000*6% = $600

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense = $1,000/$600 = 1.7:1.

So, the current earnings before interest and taxes can cover the interest expense 1.7 times.

#4 – Activity/Efficiency Ratios

It establishes the relationship of sales to net working capital Net Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities.read more. A higher ratio indicates that the company’s funds are efficiently used.

Working Capital Turnover Ratio = Net Sales/ Net Working Capital

The Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read more indicates the pace at which the stock is converted into sales. Therefore, it is useful for inventory reordering and understanding the conversion cycle.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

The Asset Turnover RatioAsset Turnover RatioThe asset turnover ratio is the ratio of a company’s net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.read more indicates the revenue as a percentage of the investment. A high ratio suggests that its assets are managed better, yielding good income.

Asset Turnover Ratio = Net Revenue / Assets

The debtors’ turnover ratio indicates how efficiently debtors’ credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more value is collected. In addition, it shows the relationship between credit sales and the corresponding receivables.

Debtors Turnover Ratio = Credit Sales / Average Debtors

X Corp. makes a total sale of $6,000 in the current year, of which 20% is cash sales. Debtors at the beginning are $800 and at the year-end are $1,600.

Credit sales = 80% of the total sales = $6,000 * 80% = $4,800

Average debtors = ($800+$1,600)/2 = $1,200.

Debtors Turnover Ratio = Credit Sales/Average Debtors = $4,800 / $1,200 = 4 times.

Conclusion

Accounting ratios are useful in analyzing the company’s performance and financial position. It acts as a benchmark and is used to compare industries and companies. However, they are more than just numbers to help understand their stability. In addition, it allows investors with stock valuation. Ratios can be used for macro-level analysis, but in-depth research needs to understand the business properly.

This article is a guide to Accounting Ratio. Here, we discuss 4 types of accounting ratios along with accounting ratio formulas and examples. You can learn more about accounting from the following articles: –

  • Formula of ROCEFinancial Analysis DefinitionTop Financial RatiosTop 4 Balance Sheet Ratios