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Accounting Ratios

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Accounting Ratios

What are Accounting Ratios?

Accounting Ratios is used as a benchmark to measure the performance of the company and is expressed as a relationship between two or more financial parameters derived from its financial statements. Accounting ratios measure the company’s operational efficiency, liquidity position, profitability, etc. There are 4 main types of accounting ratios –

  1. Liquidity Ratio
  2. Profitability Ratio
  3. Leverage Ratio
  4. Activity/Efficiency Ratio

Let us discuss each of these in detail –

Types of Accounting Ratios with Formulas

There are four types of Accounting Ratios with formulas

#1 – Liquidity Ratios

This first type of accounting ratio formula is used for ascertaining the liquidity position of the company. It is used for determining the paying capacity of the company towards its short term liabilities. A high liquidity ratio indicates that the cash position of the company is good. The liquidity ratio of 2 or more is acceptable.

Current Ratio

Current Ratio is used to compare the current assets to current liabilities of the business. This ratio indicates whether the company can settle its short term liabilities.

Current Ratio = Current Assets / Current Liabilities

Current Assets include Cash, Inventory, Trade receivables, other current assets, etc. Current liabilities include Trade payables and other current liabilities.

Example

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

Current Assets = Short Term capital + Debtors + Stock + Cash and bank = $10,000 + $95,000 + $50,000 + $15,000 =$170,000.

Current-Ratio Example 1

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

Current-Ratio Example 1-1

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

Current-Ratio Example 1-2

Quick Ratio

Quick Ratio 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 ratio

Quick Ratio = Quick Assets / Current Liabilities

Quick Assets excludes Inventory and prepaid expenses.

Cash Ratio

Cash Ratio considers only those current assets which are immediately available for liquidity. The cash ratio is considered ideal if it is 1 or more.

Cash Ratio = (Cash + Marketable securities) / Current Liabilities

#2 – Profitability Ratios

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

Gross profit Ratio

Gross Profit Ratio compares the gross profit to the net sales of the company. It indicates the margin earned by the business before its operational expenses. It is represented as % of sales. The higher the gross profit ratio more profitable is the business.

Gross profit Ratio = (Gross profits/ Net revenue from operations) X 100

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

Gross profit = Net Sales – Cost of goods sold

Cost of goods sold includes raw materials, labor cost, and other direct expenses 

Example

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 = $90,000

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

Gross profit ratio

Gross profit ratio = $10,000/ $90,000 = 11.11%

Operating Ratio

Operating Ratio expresses the relationship between operating cost and net sales. This is used to check on 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.

Net profit Ratio

Net Profit Ratio shows the overall profitability available for the owners as it considers both the operational and non-operational income and expenses. Higher the ratio, 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
Return on capital employed (ROCE)

ROCE shows the company’s efficiency with respect to generating profits in comparison to the funds invested in the business. It indicates whether the funds are utilized efficiently.

Return on capital employed = (Profits before interest and taxes / Capital employed) X 100

Example

R&M Inc. had PBIT 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
Return on capital employed = $10,000/ $400,000 = 2.5 %

Earnings per Share

Earnings Per share shows the earnings of a company with respect to one share. It is helpful to investors for decision making in relation to the purchasing/ sale of shares as it determines the return on investment. It also acts as an indicator of dividend declaration or for the issue of bonus shares. If EPS is high, the stock price of the company will be high.

Earnings per share = Profit available to equity shareholders / Weighted average outstanding shares

#3 – Leverage Ratios

These type of accounting ratios are known as solvency ratios. It determines the company’s ability to pay for its debts. Investors are interested in this ratio as it helps to know how solvent the company is to meet its dues.

Debt to Equity ratio

It shows the relationship between total debts and the total equity of the company. It is useful to measure the leverage of the company. A low ratio indicates that the company is financially secure, a high ratio indicates that the business 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

Example

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

Example 3

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

Debt ratio

Debt Ratio measures the liabilities in comparison to the assets of the company. A high ratio indicates that the company may face solvency issues.

Debt Ratio = Total Liabilities/ Total Assets
Proprietary ratio

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
Interest Coverage ratio

Interest Coverage Ratio measures the company’s 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

Example

Duo Inc. has EBIT of $1,000 and it has issued debentures worth $10,000 @ 6%

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

Example 3-1

Interest coverage ratio = EBIT / Interest expense = $1,000/$600 = 1.7:1

So the current EBIT can cover the interest expense for 1.7 times.

#4 – Activity/Efficiency Ratios

Working Capital Turnover ratio

It establishes the relationship of sales to Net Working capital. A higher ratio indicates that the company’s funds are efficiently used.

Working Capital Turnover Ratio = Net Sales/ Net working capital
Inventory Turnover ratio

Inventory Turnover Ratio indicates the pace at which the stock is converted into sales.  It is useful for inventory reordering and to understand the conversion cycle.

Inventory Turnover Ratio = Cost of goods sold / Average inventory
Asset Turnover ratio

Asset Turnover Ratio indicates the revenue as a % of the investment. A high ratio indicates that the company’s assets are managed better, and it yields good revenue.

Asset Turnover Ratio = Net Revenue / Assets
Debtors turnover ratio

Debtors Turnover Ratio indicates how efficiently the credit sales value is collected from debtors. It shows the relationship between credit sales and the corresponding receivables.

Debtors Turnover Ratio = Credit sales / Average debtors

Example

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

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

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

Example 4

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 it is used for comparing between industries and companies. Accounting ratios are more than just numbers as they help to understand the company’s stability. It helps investors in relation to stock valuation. For macro level analysis ratios can be used but to have a proper understanding of the business in-depth analysis needs to be done.

Recommended Articles

This has been a guide to what are Accounting Ratios and its Definition. Here we discuss 4 types of Accounting ratios along with Formula and Examples. You can learn more about Accounting from the following articles –

  • Financial Analysis Definition
  • Top Financial Ratios
  • Top 4 Balance Sheet Ratios
  • Types of Financial Ratios

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