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Types of Accounting Ratios and How to Analyze It

What are some the accounting ratios that is important to measures company’s financial performances? What are the formulas to calculate them?

Accounting ratios analysis is commonly used to the determine a company’s strengths and weaknesses.

It allows the company to measure its efficiency and profitability, as well as determine the relationship between one accounting variable and another on their financial statements.

It can be used to find out the relationship between figures stated in balance sheet, profit or loss statement, and other financial reports.

Types of Accounting Ratios

Some of the most important accounting ratios to determine a business financial performance are:

1. Liquidity Ratios

Liquidity ratios, often known as Balance Sheet ratios, are further divided into:

  • Current Ratio
  • Quick Ratio
  • Cash Ratio

The primary goal of any liquidity ratio is to determine the company’s short-term solvency situation. It indicates the company’s efficiency and ability to pay off existing liabilities and debts with current assets.

The formula for these ratios in accounting are:

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = Current Assets Less Inventory /Current Liabilities

Cash Ratio = Cash + Marketable Securities / Current Liabilities

2. Profitability Ratios

Profitability Ratios are used to assess a company’s aptitude and efficiency in using its capital to generate revenue and, ultimately, profits.

It reflects the relationship of the unit in terms of percent of sales, and is usually expressed in percentage terms.

There are 4 types of profitability ratios in accounting:

Gross Profit Ratio = (Gross Profit / Net Sales) x 100

Net Profit Ratio = (Net Profit / Net Sales) x 100

Operating Expense Ratio = ((Cost of Goods Sold + Operating Expense) / Net Sales) x 100

Return on Capital Employed = (Profit before Interest and Taxes / Capital Employed) x 100

3. Activity Ratios

Activity Ratios are used to evaluate a company’s capacity to manage and turn its assets into revenue and cash. It demonstrates the company’s efficiency in generating income by leveraging its assets.

There are 4 types of activity ratios in accounting:

  • Inventory Turnover Ratio: This ratio calculates the amount of time it takes to turn inventory into sales.
  • Debtors Turnover Ratio: This ratio reflects how quickly credit debtors are turned into cash, or how long it takes.
  • Total Assets Turnover Ratio: This ratio assesses how effectively the company manages its assets in order to create income.
  • Fixed Assets Turnover Ratio: This ratio assesses how effectively the company manages its fixed assets in order to generate income.

The formulas for these ratios in accounting are:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Debtors Turnover = Net Sales / Average Debtors

Total Assets Turnover = Sales / Average Total Assets

Fixed Assets Turnover = Sales / Average Fixed Assets

4. Leverage Ratios

Leverage ratio is used to determine the long term solvency aspects of the company, which also comes in 4 types of ratios.

  • Debt to Equity Ratio: It refers to the relationship between the company’s total debts and its entire equity. A low debt to equity ratio, which is used to measure a firm’s leverage capability, usually indicates that the company has solid financial security.
  • Debt Ratio: This ratio describes the relationship between a company’s total liabilities and its total assets.
  • Proprietary Ratio: This ratio describes how the company’s total shareholder money are invested in its total assets.

The formulas for these leverage ratios in accounting are:

Debt Equity Ratio = Total Debt / Total Equity

Debt Ratio = Total Liabilities / Total Capital

Proprietary Ratio = Shareholders Funds / Total Assets

Why Is It Important to Understand Accounting Ratios?

The purpose of accounting ratios are to analyze company’s performance whether it’s stable enough and able to utilize its assets efficiently.

It is also used as a tool to forecast and plan for the future especially in giving an insight for decision making.

Accounting ratios are used not just to analyze a company’s performance internally, but also to compare it to the performance of other organizations in related industries.

As an investor, an understanding about these accounting ratios could help you understand a company’s prospect better.

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