Accounting Ratios

What is an Accounting Ratio?

Definition – Accounting ratios are estimated financial statements summarizing financial information used by investors, analysts, and executives to allocate resources among different activities. For example, in simple terms, an accounting ratio helps determine how much money investment will generate while being viewed from a discounted rate of return (a rate below which an asset’s cash flows are discounted relative to the purchase price) or from interest.

An effective ratio should be based on past performance, economic analysis, cost-benefit analysis, and cash-generating activities. Accounting ratios aren’t always easy to understand because they are generally based on broad percentages or averages rather than individual facts. However, they can be beneficial in gauging how well a business is running on a day-to-day basis.

Accounting ratios are an essential performance indicator that informs investors about the health of a business’s profitability and performance.

Company comparison is a crucial aspect of the financial markets because it provides investors with reliable insight into its profitability, income, and profitability ratio.

Types of accounting ratios

1. Gross margin and operating margin

-Gross margin is the total amount of profit a company makes; after all, operating costs (such as salaries and interest) are accounted for. 

-Operating margin is the amount of profit a company generates before taxes, and other costs (such as salaries and interest) are accounted for.

2. Debt-to-equity ratio

A debt-to-equity ratio is the amount of debt a company has relative to its equity. This ratio shows how much debt is held by a company relative to its net worth. For example, if A owns 100 shares of stock and B owns 1 share of stock, then A and B have the same debt burden as before, but now A has to pay $10 in interest on the $1 invested in the company.

3. Quick Ratio

The quick ratio is generally used for a company’s capital adequacy analysis. It indicates the company’s ability to meet current financial obligations and liquid assets. For example, if a company has gross liabilities but short-term liquid assets, then the quick ratio should be higher than 100%.

4. Dividend Payout ratio

The percentage of a company’s earnings paid out to shareholders in either dividend, or the form of interest or bonuses is known as the dividend payout ratio. Dividends are typically given to owners of common stock when their company achieves positive earnings. Interest is typically charged to the owners of preferred stock (which means they can’t simply buy common stock without paying interest), and bonuses can be awarded to those who purchased stock at the pre-dividend price or those who held their position through prior purchases.

Common Accounting Ratios

There are numerous financial ratios used throughout the industry. These break down into finance ratios, cash flow ratios, and even liquidity ratios, among others.

Commonly Used Debt Ratios and Formulas

1. Debt-to-Equity Ratio

A company’s debt-to-equity ratio is calculated by dividing the number of its liabilities by its shareholder equity.

 Debt-to-Equity Ratio = Liabilities (Total) / Shareholder Equity (Total)

2. Debt Ratio

The debt ratio compares a company’s total liabilities to its total assets. Theoretically, companies with a high debt ratio are riskier investments.

Debt Ratio =  Total Liabilities/Total Assets

Commonly Used Liquidity Ratios and Formulas

1. Current Ratio

The current ratio measures the capacity to pay short-term obligations. It is calculated as current assets divided by current liabilities.

Current Ratio = Current Assets/Current Liabilities

2. Quick Ratio

A quick ratio measures a company’s ability to pay its near-term obligations and is calculated as current assets minus inventory and prepaid expenses divided by current liabilities.

Quick Ratio = [Current Assets – Inventory – Prepaid Expenses] / Current Liabilities

Commonly Used Profitability Ratios and Formulas

1. Return on Equity

The return on equity (ROE) is a profitability ratio used to compare a company’s profits with its shareholder equity.

Return on Equity = Net Income / Average Shareholder Equity

2. Gross margin

Gross margin is a measure of the efficiency of the firm in converting revenue into profit.

Gross Margin = Gross Profit / Net Sales

3. Return on Assets

The return on assets ratio is useful for measuring a company’s ability to generate profit.

Return on Assets = Net Income/Total Assets

In a nutshell, Accounting ratios are the numbers used to break down financial information. They may be applied to balance sheets, income statements, cash flows, or other parts of your financial statements. Accounting ratios help an investor or owner of a business quickly and easily gauge how a company is faring financially.