Accounting ratios

3 key takeaways

• Accounting ratios help assess a company’s financial health and performance.
• They provide insights into profitability, liquidity, efficiency, and solvency.
• Common accounting ratios include the current ratio, debt-to-equity ratio, and return on equity.

What are accounting ratios?

Accounting ratios, also known as financial ratios, are quantitative tools that help analysts, investors, and managers assess the financial health and performance of a company. These ratios are derived from the information contained in a company’s financial statements, such as the balance sheet, income statement, and cash flow statement. By comparing different figures, accounting ratios provide insights into various aspects of a company’s operations, including profitability, liquidity, efficiency, and solvency.

Importance of accounting ratios

Accounting ratios are important for several reasons:

• Performance evaluation: They help measure how well a company is performing in different areas, such as profitability and efficiency.
• Comparative analysis: Ratios allow for comparisons between companies of different sizes and across industries.
• Trend analysis: Tracking ratios over time helps identify trends and potential issues in a company’s financial performance.
• Decision-making: Managers, investors, and other stakeholders use these ratios to make informed decisions about investments, operations, and strategies.

Common types of accounting ratios

Here are some common types of account ratio:

1. Liquidity ratios: Measure a company’s ability to meet short-term obligations.
   • Current ratio: Current assets / Current liabilities
   • Quick ratio: (Current assets – Inventory) / Current liabilities
2. Profitability ratios: Assess a company’s ability to generate profit.
   • Gross profit margin: (Gross profit / Revenue) x 100
   • Net profit margin: (Net income / Revenue) x 100
   • Return on equity (ROE): (Net income / Shareholder’s equity) x 100
3. Efficiency ratios: Evaluate how effectively a company uses its assets.
   • Inventory turnover: Cost of goods sold / Average inventory
   • Accounts receivable turnover: Net credit sales / Average accounts receivable
4. Solvency ratios: Indicate a company’s ability to meet long-term obligations.
   • Debt-to-equity ratio: Total liabilities / Shareholder’s equity
   • Interest coverage ratio: Earnings before interest and taxes (EBIT) / Interest expense

Examples of accounting ratios

• Current ratio: A company with current assets of $200,000 and current liabilities of $100,000 would have a current ratio of 2 ($200,000 / $100,000), indicating strong liquidity.
• Gross profit margin: A company with gross profit of $150,000 and revenue of $500,000 would have a gross profit margin of 30% ($150,000 / $500,000 x 100), showing its profitability in generating revenue from its core activities.
• Debt-to-equity ratio: A company with total liabilities of $300,000 and shareholder’s equity of $600,000 would have a debt-to-equity ratio of 0.5 ($300,000 / $600,000), suggesting it has half as much debt as equity.

Real-world application

Consider an investor analyzing two competing companies in the same industry. By comparing key accounting ratios, such as the current ratio, net profit margin, and return on equity, the investor can determine which company is more financially stable, profitable, and efficient. This analysis helps the investor make an informed decision about where to allocate their investment.

Understanding accounting ratios is essential for evaluating a company’s financial health and making informed business decisions. Exploring other related topics like financial statement analysis, ratio analysis, and benchmarking can provide further insights into how these metrics are used in practice.