Want to learn about Accounting ratios? In this blog, we provide a cheat sheet of financial ratios and some basic accounting equations.
Accounting ratios
The accounting ratios are ratios that compare two or more financial data. The ratios are great tools to analyze the financial statements of companies. Various stakeholders in the business examine the ratios to understand the financial status of the company.
What are accounting ratios?
Accounting ratios or financial ratios are comparisons made between one set of figures with another set of figures. Analysts use the ratios to determine if the company can pay off its debt and find profitability. The ratio can predict if the company is likely to go bankrupt.
We can source the ratio from – balance sheet, income statement, and cash flow statement. Statements about the change in equity are a valuable source of data. There are different types of financial performance ratios are –
- Liquidity Ratios
- Assets Turnover Ratios
- Financial Leverage Ratios
- Profitability Ratios
- Dividend Policy Ratios
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Importance of accounting ratios
The financial statements are elaborate documents. Different items on the statement are interrelated. Accounting ratios are important because –
- Accounting ratios help us to analyze and scrutinize past results. The ratios help to analyze the relationship with different items.
- We can derive the ratios after analyzing and scrutinizing past results. Companies use the ratios to prepare budgets, estimates, formulating policies, and prepare an action plan.
- Trend analysis helps us to take into account the time dimension while analyzing the account statement. We can determine if the company’s performance is improving and deteriorating over the years.
- Ratio analysis helps to determine how efficiently the company runs and how it utilizes the company’s assets.
- Compare the performance of two companies having similar products, or the performance of two departments in the same company.
Types of financial ratios
Accounting ratios help to measure the efficiency and profitability of an organization. The different types of financial ratios are-
- Gross margin and operating margin – The income statement of the company contains information like company sales, expenses, and net income. Accountants get an idea about company earnings. Figures used to analyze company profitability are –
We can calculate gross profit or gross margin by dividing gross profit by sales. High gross profit indicates the company has a higher proportion of profits rather than expenses.
Operating profit or operating margin is a percentage of sales. It is the ratio of operating profit by sales.
- Debt to Equity Ratio – The debt to equity ratio is an important measure in the balance sheet. We calculate the ratio by dividing debt by equity. The ratio shows how much business is leverage. It shows how much debt it is using to finance operations as opposed to company funds.
- Quick Ratio – The quick ratio or acid-test ratio helps to or show a company’s short-term liquidity and measures if the company can measure if the company can meet its short-term obligations with its liquid assets.
- Dividend Payout Ratio – provides data for ratios dealing with cash. For example dividend payout ratio is the percentage of net income paid to investors through dividends.
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Frequently used accounting ratios
Accounting formulas and bookkeeping processes are tedious,but gives a clear picture of the financial health of your company. The accounting ratios help you make important decisions. Here are some the most important financial ratios to analyze a company.
1. Profitability ratios
These ratios help accountants measure business earnings versus expenses.
- Return on Assets indicates the profit made by the company compared to the assets.
- Return on Equity shows profitability in the stakeholder’s investment.
- Profit Margin shows the income that comes from sales.
- Earnings Per Share indicates your profitability from outstanding shares.
Total assets formula – Assets are resources owned by the company for future economic benefits. Total assets formula = non-current + current assets.
Non-current assets are assets held for more than one financial year and are difficult to convert into cash or equivalent.
Current Assets are assets can be easily converted into cash and cash equivalent within one financial year. Ideally, total assets should equal the sum of shareholders equity and total liabilities combined.
2. Liquidity ratio formula
Liquidity ratios are financial metrics to determine a company’s ability to pay the current debt without raising more capital. Internal or external experts carry out the analysis. Here are the different liquidity ratios with the liquidity ratio formulas.
- Current Ratio = Current assets/current liability
- Quick Ratio = (Cash + marketable securities+ account receivable)/current liabilities
- Days sale Outstanding = Average account receivables/Revenue per day
3. Equity ratio formula
The equity ratio or solvency ratio, measures the assets funded by the owner’s investment. It compares total equity in the company to total assets. A low equity ratio means the company acquires assets by taking debt which is risky. A high equity ratio indicates minimal debt. The equity ratio formula = Total Equity/Total Assets.
4. Accounts payable turnover ratio
The accounts payable turnover ratio is a short-term liquidity measure. We use it to quantify how fast a company pays its suppliers. The ratio measures how many times the company pays the payable amount during a specified period.
Account payable is short-term debt owed to suppliers and creditors.
Accounts payable turnover ratio =(BAP + EAP)/2TSP
where:AP = Accounts payable
TSP = Total supply purchases
BAP = Beginning accounts payable
EAP = Ending accounts payable
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5. Average total assets formula
The average total assets is the average amount of assets recorded on a company’s balance sheet at the end of the year and the previous year. Accountants use it to compare the sales figure of the current year, to calculate the assets required to support the sales.
The average total assets formula = (Aggregate assets at end of current year + Aggregate assets at end of the preceding year)/ 2
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6. Asset management ratios
Asset management ratios are also called turnover ratios or efficiency ratios. You use the ratios to analyze how effectively and efficiently small businesses manage their assets to produce sales. Here are the different assets management ratios.
- Inventory Turnover Ratios are applicable if a business sells physical products. The Inventory turnover ratio = Net Sales/Inventory.
- Day Sales Inventory will tell the management how many days does it take to sell inventory. The Day sale inventory = 365/Inventory Turnover.
7. Industry average ratios
You use industry average ratios to evaluate industry performance. We can calculate industry average ratios by comparing the financial statements of many firms. Analysts use industry average ratios for trend analysis and industry comparison.
8. Market value ratios
You can evaluate the current share prices of public-held company stock. The ratios help investors determine, if share prices are over-priced or under-priced. The market value ratios are
- Book value per share
- Dividend Yield
- Earnings per share
- Market Value per share
- Price/earnings ratio
9. Working capital ratios formula
Working Capital ratios is also called current ratios or liquidity ratios. The ratios measures the company’s ability to pay off its current liabilities with current assets. The ratio shows the liquidity of the company. It is healthy if a company can pay off current liabilities with current assets (cash, cash equivalent, and marketable securities). The working capital ratios formula = current assets/current liabilities.
10. Cash coverage ratio formula
The cash coverage ratio is a liquidity ratio. It measures the company’s ability to pay off current liability with only cash and cash equivalent. Creditors examine the ratio to find out if the company maintains an adequate cash balance to pay off current debt. The cash coverage ratio formula = (cash + cash equivalent)/total current liabilities.
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11. Sales to assets ratio
We can calculate sales to assets ratio by dividing total sales by total assets. It can determine how many assets the company has relative to the revenue generated. Sales to assets ratio = total assets/sales revenue. You can determine if a company is using assets by studying the sales to assets ratio.
12. The ratio of liabilities to stockholders’ equity
You use the ratio of liabilities to stockholder’s equity to evaluate a company’s financial leverage. It is an important financial ratio. Accountants use the ratios to measure which company is funding itself through debts versus wholly funded groups. The ratio of liabilities to stock equity = Total liabilities/Total Shareholders Equity.
13. Leverage ratio examples
Leverage ratios are popular in accounting. The financial ratios help determine the ability of a company to meets its financial obligation. Common leverage ratios examples are –
- Debt-equity ratio = total liabilities/total shareholders’ equity
- Equity multiplier = total Assets/Total Equity
- Degree of financial leverage = (SD+LD+SE)/(SD+LD) where, SD=short-term debt, LD=long-term debt, SE=shareholders’ equity
- Consumer leverage ratio = Total household debts/Disposal personal income.
14. Average total assets formula
The average total assets is the average amount of assets recorded on a company’s balance sheet at the end of the year and the previous year. It is used to compare the sales figure of the current year, to calculate the assets required to support the sales.
The average total assets formula = (Aggregate assets at end of current year + Aggregate assets at end of the preceding year)/ 2
15. Asset management ratios
Asset management ratios or turnover ratios or efficiency help you analyze how effectively and efficiently small businesses manage their assets to produce sales. The different assets management ratios are-
- Inventory Turnover Ratios are applicable if a business sells physical products. The Inventory turnover ratio = Net Sales/Inventory
- Day Sales Inventory will tell the management how many days does it take to sell inventory. The Day sale inventory = 365/Inventory Turnover.
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16. Industry average ratios
You use industry average ratios to evaluate industry performance. We can calculate industry average ratios after comparing the financial statements of hundreds of firms. Analysts use industry average ratios for trend analysis and industry comparison.
17. Market value ratios
You can evaluate the current share prices of public-held company stock. The ratios help potential and current investors determine if share prices are over-priced or under-priced. The market value ratios are –
- Book value per share
- Dividend Yield
- Earnings per share
- Market Value per share
- Price/earnings ratio
18. Working capital ratios formula
Working Capital ratios or current ratios or liquidity ratios measures the company’s ability to pay off its current liabilities with current assets. The ratio shows the liquidity of the company. It is healthy when companies pay off current liabilities with current assets (cash, cash equivalent, and marketable securities). The working capital ratios formula = current assets/current liabilities.
19. Cash coverage ratio formula
The cash coverage ratio is a liquidity ratio measuring the company’s ability to pay off current liability with only cash and cash equivalent. Creditors examine the ratio to ascertain if the company maintains an adequate cash balance to pay off current debt. The cash coverage ratio formula = (cash + cash equivalent)/total current liabilities.
20. Sales to assets ratio
The sales to assets ratio is calculated by dividing total sales by total assets. The ratio helps to determine how many assets the company has relative to the revenue generated. Sales to assets ratio = total assets/sales revenue. You can determine if a company is using assets by studying the sales to assets ratio.
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21. The ratio of liabilities to stockholders’ equity
You use the ratio of liabilities to stockholder’s equity for evaluating a company’s financial leverage. It is considered to be an important financial ratio and is used to measure which company is funding itself through debts versus wholly funded groups. The ratio of liabilities to stock equity = Total liabilities/Total Shareholders’ Equity.
22. Leverage ratio examples
Leverage ratios are widely used in accounting financial ratios that help determine the ability of a company to meets its financial obligation. Common leverage ratios examples are –
- Debt-equity ratio = total liabilities/total shareholders’ equity
- Equity multiplier = total Assets/Total Equity
- Degree of financial leverage = (SD+LD+SE)/(SD+LD) Where: SD=short-term debt, LD=long-term debt, SE=shareholders’ equity
- Consumer leverage ratio = Total household debts/Disposal personal income.
What are balance sheet ratios?
The most important financial ratio balance sheet ratio is –
- The current ratio is the ratio of current assets to current liabilities. It indicates the company’s ability to pay off its short-term liabilities with current assets. It is an important measure of liquidity.
- Debt to equity ratio or financial gearing is the ratio of total long-term debt to shareholder funds.
- Return on Assets measures the efficiency with total assets of the company can generate profit.
- The solvency ratio is the ratio of the sum of net income and depression to the total liabilities. We can use the ratio to determine if the company can pay off the long-term debt of the company.
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How to calculate average total assets?
How to calculate average total assets?
Average total assets = Total assets (current year) + Total assets (previous year)/2.
We can calculate the average total assets as the sum of the total assets each month divided by twelve.
Average total assets = (Total assets at P1+Total assets at P2+…+Total assets at P12)/12
We use the formula when the management wants an in-depth analysis for more accurate results.
List of liquidity ratios
Basic liquidity ratios are financial ratios to find out a company’s ability to pay the short-term debt obligations. We use the ratio to determine if the current or liquid assets can pay off the current liabilities. The list of liquidity ratios is as follows
- The current ratio is the ratio of current assets to the current liabilities.
- The quick ratio is the ratio of the sum of cash, account receivables, and marketable securities to the current liabilities. Analysts consider the quick ratio to be a stricter check than the current ratio.
- The cash ratio is the ratio of the sum of cash and market securities to the current liabilities. The cash ratio only considers a company’s most liquid assets.
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What are the most important financial ratios?
The most important financial ratios are:-
1. Quick ratio The quick ratio is one of the most important accounting ratios of a company. It is a good indicator of a company’s liquidity.
Quick ratio = (Current Assets – Inventory)/Current Liabilities
2. Debt to equity ratio helps to determine if a business can repay debt using equity as a metric.
Debt to equity ratio = Total liabilities/ Shareholder’s equity
3. The working capital ratio determines how well a company can pay its existing debt.
Working capital ratio = current assets/current liabilities
4. Price to earnings ratio measures how much investor would pay for dollars earned. You can learn if stock is overvalued or undervalued.
Price to earnings ratio = Share price/Earnings per share.
5. Profit margin shows analysts how effectively a company is managing its costs.
Profit margin = Profit/Revenue
What is ratios analysis?
Ratio analysis helps to gain insight into a company’s liquidity, operational efficiency, and profitability by analyzing the financial statements like balance sheet and income statement. There are different accounting ratios used for ratio analysis. We can group ratio analysis under the following categories as below.
- Liquidity ratios measure the company’s ability to repay debt using current assets. If a company is unable to repay its debt it can convert its assets to cash and settle the pending debt.
- Solvency ratios measure the company’s long-term financial feasibility. The ratios compare the company debt to its assets, equity, or yearly earnings.
- Profitability ratios measure the ability to earn profit about its associated expenses.
- Efficiency ratios measure how effectively a company is using its assets and liabilities to generate sales and earn profits.
- Coverage ratios measure the ability to repay its debt `and other obligations.
- Market prospect ratios help investors determine the return on investments.
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How to calculate profitability?
Profitability is a significant parameter to measure the financial performance of a company. It helps you to plan and check the profits earned. Use profitability to calculate your breakeven point. The profitability ratio formula will help you calculate profitability
1. Gross Profit Margin is the ratio of gross profit to sales. It measures if a business can recover the cost of production from its earnings.
Gross profit margin = Gross Profit/sales
Where, Gross Profit = Sales – Purchase – Direct Cost.
2. Net Profit Margin is the ratio of net profit to sales. The company earns net profit after reducing operational costs, depreciation, and dividend from gross profit.
Net profit margin = Revenue – Cost/Revenue.
3. Operating profit margin is the percentage of earnings to the sale before interest expenses and income taxes.
Operating Profit margin = Operating profit/sales
Where, Operating Profit = Sales – Expenses excluding interest and taxes.
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