When running a small business, one of the most essential components is having a basic understanding of accounting. Admittedly, it can be quite time-consuming and annoying to remember and keep track of various formulas and bookkeeping processes. Tediousness aside, it can provide you with a clear picture of your company’s financial health. It is with this insight that you can make important decisions. Ideal tools for this task include accounting ratios, which offer quick ways to evaluate the status of a business’s finances.
Accounting Scholar states that ratios are popular accounting formulas when it comes to business analysis. By analyzing your finances with these ratios, you can identify trends and other data that influence crucial business decisions.
What is it?
‘Accounting ratios’ are a vital sub-set of financial ratios. They are a group of metrics that aid in measuring the efficiency and profitability of a company. The source of the information it uses is the company’s financial reports. These ratios provide a way of illustrating the relationship between one accounting data point to another. Moreover, they serve as the foundation of ratio analysis.
The purpose of an accounting ratio is to compare two line items in a company’s financial statements. These are primarily made up of the following:
- Income statement
- Balance sheet
- Cash flow statement
These ratios are very useful when evaluating a company’s fundamentals. What’s more, they provide information concerning a company’s performance during the last quarter of the fiscal year.
Why they are important
Analyzing accounting ratios is imperative for determining a company’s financial well-being. Oftentimes, it can specify areas that are responsible for dragging the profitability of a company down. In doing so, it points out what needs improvement. Determining the competence of new management strategies, new products, and operational procedures alterations is achievable by analyzing accounting ratios.
In addition, accounting ratios function as important tools when comparing companies within an industry. It is beneficial for not just the company itself but investors as well. A company is able to see how it stacks up against its peers. Investors, meanwhile, can use accounting ratios as a means to figure out which company is better.
A meticulous accounting analysis can prove itself to be a complex task. Be that as it may, calculating accounting ratios is actually an easy process. One that focuses on dividing two line items residing on a financial statement. This process provides a quick form of clear analysis for those who utilize it, business owners and investors alike.
Uses and users
There are two purposes for the analysis of financial ratios:
- Keeping track of company performance. Determining individual financial ratios per period and tracking value change over time helps spot potential trends in a company. For example, a growing debt-to-asset ratio is indicative of a company being overwhelmed with debt. Furthermore, it may eventually come face-to-face with default risk.
- Making comparative judgments in regards to company performance. Comparing financial ratios with major competitors identifies whether a company’s performance is better or worse than the industry average. For example, comparing return on assets between companies allows analysts or investors to determine which company efficiently uses its assets.
Those who use financial ratios typically include parties that are external and internal to the company:
- External users: These are financial analysts, creditors, retail investors, regulatory authorities, competitors, tax authorities, and industry observers.
- Internal users: These are the employees, management team, and owners.
There are various types of accounting ratios, four of which are listed below. These are only a few of the many accounting ratios that corporations and analysts use for company evaluation. There are so many more that highlight the different aspects of a company.
1- Gross Margin & Operating Margin
The income statement contains informative material regarding company sales, net income, and expenses. Moreover, it presents an earnings summary and the number of shares outstanding that help calculate earnings per share (EPS). These are among the most popular data points analysts use to evaluate the overall profitability of a company.
Gross profit as a percent of sales is known as ‘gross margin’. Its calculation is done by dividing gross profit by sales. Let’s use a gross profit of $70,000 and $100,000 for sales as an example. In this case, the gross profit margin is 70%. A higher gross profit margin implies that a company is maintaining a higher revenue proportion as profit instead of expenses.
Operating profit as a percentage of sales is the ‘operating margin’. Its calculation is done by dividing operating profit by sales. For example, imagine that a company’s operating profit is $40,000 and its sales $100,000. In this case, the operating profit margin is 40%.
2 – Debt-To-Equity Ratio
The balance sheet gives accountants an idea of a company’s capital structure. In this sheet resides one of the most crucial measures and that is the ‘debt-to-equity’ (D/E) ratio. Calculating it is done so through dividing debt by equity.
For example, let’s assume that a company has debt equal to $100,000 and equity equal to $50,000. In this particular case, the debt-to-equity ratio is 2 to 1. The debt-to-equity ratio illustrates how much a business is leveraged. In other words, how much debt it uses in order to finance operations rather than its internal funds.
3 – The Quick Ratio
The ‘quick ratio’ (aka. the ‘acid-test ratio’) indicates a company’s short-term liquidity. Additionally, it gauges a company’s inherent ability to meet its short-term obligations through its most liquid assets. Due to the main concern being with the most liquid assets, the ratio omits the inventories from current assets.
4 – Dividend Payout Ratio
The cash flow statement supplies data for ratios that are primarily dealing with cash. For instance, the ‘dividend payout ratio’ is the percentage of net income paid out to investors via dividends. Dividends and share repurchases are both, according to many, outlays of cash. Moreover, they typically reside in the cash flow statement.
For example, let’s say that dividends are $100,000 and the income is $500,000. In this situation, calculating the dividend payout ratio is through dividing $100,000 by $500,000. This equals out to 20%. The higher the dividend payout ratio indicates the higher percentage of income that a company pays out as dividends. This is in stark contrast to reinvesting back into the company.
Categories & Formulas
Generally speaking, accounting ratios are categorized into the following groups:
- Liquidity ratios
- Efficiency ratios
- Leverage ratios
- Profitability ratios
- Market value ratios
1 – Liquidity Ratios
‘Liquidity ratios’ measure a company’s ability to pay back both short-term and long-term obligations. These ratios typically include the following information:
- The current ratio measures a company’s ability to repay short-term debts with current assets. Current ratio = Current assets / Current liabilities
- Acid-test ratio measures a company’s ability to use quick assets to pay off short-term debts. Acid-test ratio = Current assets – Inventories / Current liabilities
- The cash ratio calculates a company’s ability to use cash and cash equivalents to repay short-term liabilities. Cash ratio = Cash and Cash equivalents / Current Liabilities
- The operating cash flow ratio is a calculation of how many times a company can pay off current debts. Specifically, with cash generated in a specific period. Operating cash flow ratio = Operating cash flow / Current liabilities
2 – Efficiency Ratios
‘Efficiency ratios’ (aka. ‘activity financial ratios’) assesses how well a company utilizes its assets and resources. These ratios typically include the following information:
- Asset turnover ratio measures the company’s capability to generate sales from assets. Asset turnover ratio = Net sales / Average total assets
- Inventory turnover ratio calculates how often a company’s inventory sells and undergoes replacement over a specific period. Inventory turnover ratio = Cost of goods sold / Average inventory
- Accounts receivable turnover ratio measures the number of times a company transforms receivables into cash over a given period. Receivables turnover ratio = Net credit sales / Average accounts receivable
- Day sales in inventory ratio determines the average number of days that a company holds inventory. Specifically, before they sell it to customers. Days sales in inventory ratio = 365 days / Inventory turnover ratio
3 – Leverage Ratios
‘Leverage ratios’ measure the exact amount of capital that originates from debt. Put simply, leverage financial ratios are tools for evaluating a company’s level of debt. These ratios typically include the following information:
- Debt ratio calculates the relative amount of a company’s assets that debts may provide. Debt ratio = Total liabilities / Total assets
- The debt-to-equity ratio calculates the total weight of debt and financial liabilities against the equity of shareholders. Debt to equity ratio = Total liabilities / Shareholder’s equity
- Interest coverage ratio illustrates how a company can effortlessly pay its interest expenses. Interest coverage ratio = Operating income / Interest expenses
- The debt service coverage ratio shows how a company can pay its debt obligations without difficulty. Debt service coverage ratio = Operating income / Total debt service
4 – Profitability Ratios
‘Profitability ratios’ gauge a company’s ability to produce income relative to various factors. These include revenue, equity, operating costs, and balance sheet assets. Profitability financial ratios typically include the following information:
- The gross margin ratio compares a company’s gross profit to its net sales. Doing so will present how much profit a company generates following the payment of its cost of goods sold. Gross margin ratio = Gross profit / Net sales
- The operating margin ratio compares a company’s operating income to its net sales, thus determining operating efficiency. Operating margin ratio = Operating income / Net sales
- Return on assets ratio measures the efficiency of a company utilizing its assets to bring in a profit. Return on assets ratio = Net income / Total assets
- The return on equity ratio measures just how efficiently a company uses its equity as a means to generate profit. Return on equity ratio = Net income / Shareholder’s equity
5 – Market Value Ratios
‘Market value ratios’ help evaluate the total share price of a company’s stock. These ratios typically include the following information:
- The book value per share ratio calculates a company’s per-share value by drawing from the equity that’s available to shareholders. Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
- Dividend yield ratio gauges the dividend amount credited to shareholders comparative to the market value per share. Dividend yield ratio = Dividend per share / Share price
- The earnings per share ratio determines the amount of net income the company earns for each share outstanding. Earnings per share ratio = Net earnings / Total shares outstanding
- Price-earnings ratio compares a company’s earnings per share to its share price. Price-earnings ratio = Share price / Earnings per share