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 –
- Liquidity Ratio
- Profitability Ratio
- Leverage Ratio
- 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 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 Assets include Cash, Inventory, Trade receivables, other current assets, etc. Current liabilities include Trade payables and other current liabilities.
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 Liabilities = Debentures + Trade payables + Bank Overdraft = $50,000 + $40,000 +$40,000 = $130,000
Current Ratio = $170,000/ $130,000 = 1.3
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 Assets excludes Inventory and prepaid expenses.
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.
#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.
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
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 = $10,000/ $90,000 = 11.11%
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 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.
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.
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 = $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.
#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.
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
Debt Ratio measures the liabilities in comparison to the assets of the company. A high ratio indicates that the company may face solvency issues.
It shows the relationship between total assets and shareholders’ funds. It indicates how much of shareholders’ funds are invested in the 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.
Duo Inc. has EBIT of $1,000 and it has issued debentures worth $10,000 @ 6%
Interest expense = $10,000*6% = $600
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.
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.
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.
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.
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
Debtors Turnover Ratio = Credit Sales/Average debtors = $4,800 / $1,200 = 4 times
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.
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
The post Accounting Ratios appeared first on .