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Financial statements contain financial information about a company’s financial situation. Furthermore, in order to make important financial decisions, business owners, analysts, and other stakeholders examine, compare, and interpret this financial data. However, such information is interpreted using financial statement analysis tools and methodologies. One such popularly used tool is accounting ratio analysis. In this article, we have covered each type of accounting ratios, their formula, and importance of each ratio.

What are Accounting Ratios?

Accounting ratios are an important tool for analysing financial statements. It is a comparison of two or more financial data that is used to analyse a company’s financial statements. These depict a connection between two or more accounting numbers obtained from financial statements. It is a useful tool for shareholders, creditors, and other stakeholders to understand a company’s profitability, strength, and financial health. This is also known as financial ratios, which are used to track corporate performance and make key business choices.

All of these sorts of ratios are used to track business performance and compare results to those of competitors. Additionally, such ratios can be stated as a fraction, %, proportion, or number of times. The financial statements determine the correctness and efficiency of accounting ratios as a financial statement analysis tool. This is because the two or more accounting statistics used to calculate a financial ratio are obtained from such statements. As a result, if the financial statements contain incorrect data, the ratios will also portray an inaccurate analysis of the company’s financial results.

In addition, the accounting numbers used to calculate ratios should be related in some way. This is because a financial examination of the company’s financial outcomes would be meaningless if the statistics were unrelated.

Types of Accounting Ratios

  • Liquidity Ratios
  • Profitability Ratios
  • Solvency Ratios
  • Activity or Efficiency Ratio

Liquidity Ratios

The liquidity ratio is used to determine whether or not a company has enough cash on hand to pay down its short-term debts. A high liquidity ratio indicates that the corporation will be able to pay its creditors. It is allowed to have a liquid ratio of 2 or more.

RatioFormulaObjective
Current Ratio: Current assets include cash, inventory, accounts receivable or debtors, interest receivable, etc
Current liabilities include accounts payable or creditors, income tax payable and any other current liabilities
{(Current Assets)/(Current Liabilities)}This is the most widely used liquidity ratio for comparing a company’s current assets to its current liabilities.
The current ratio can be used to determine whether or not a company will be able to pay its debts in the next twelve months.
Quick Ratio: Quick assets excludes assets such as inventory and prepaid expenses which are difficult to liquidate quickly.{(Quick Assets)/(Current Liabilities)}Acid test is another name for Quick Ratio. The quick ratio is a more cautious approach to determining a company’s short-term solvency. It solely comprises the company’s quick assets, which are its most liquid assets.
Cash Ratio: The cash ratio is a ratio that compares a company’s total cash and cash equivalents to its current liabilities. This metric represents a company’s ability to meet short-term debt obligations with its most liquid assets.{(Cash + Marketable securities )/(Current Liabilities)}This ratio converts current assets into an account that is immediately available to a company in order to pay its liabilities. Any company with a Cash Ratio of one or greater is regarded as financially sound.

Profitability Ratio

Profitability ratios are a group of financial indicators that are used to evaluate a company’s ability to create earnings over time in relation to its revenue, operational costs, assets, or shareholders’ equity. The evaluation is done by utilising financial information from a certain point in time. Efficiency ratios assess how successfully a corporation uses its assets internally to generate income. These efficiency ratios can be compared to profitability ratios (as opposed to after-cost profits).

Higher ratio outcomes are often more beneficial. However, such a ratio outcome must be compared to

  • The results of similar companies
  • The company’s own previous performance
  • Industry average
RatioFormulaObjective
Gross Profit Margin: Revenue is the income from sale of goods or services
Cost of goods sold, as the name suggests, is the cost that a company incurs to produce the goods that it sold. COGS includes raw materials, processing cost, labour, and other production expenses. 
{(Revenue – Cost of Goods Sold (COGS))/(Revenue)}
Gross Profit = Revenue − Cost of Goods Sold
Using the Gross Profit Ratio, any company can compare its performance to that of its competitors or to that of its own historical performance.
The gross profit ratio expresses the proportion of factory costs to sales revenue.A higher gross profit margin shows that a company’s operations are more efficient.
The Gross Profit Margin compares a company’s gross profit to its sales revenue. This margin shows how much money a company makes after all of the costs of producing goods and services have been deducted.
Operating Margin: Operating income is also known as EBIT earning before interest and taxes. 
EBIT, or operational earnings = Revenue minus cost of goods sold (COGS) and normal selling, general, and administrative costs of running a firm, excluding interest and taxes,
{(Gross Profits- Operating Expense)/(Revenue)}The operating margin quantifies how much profit a company generates on a dollar of sales after paying for variable expenses. Such variable expenses include production expenses, wages and raw materials, but before paying interest or taxes. Higher ratios indicate that a company’s operations are efficient and that it is good at converting revenues into profits.

Unlike Gross Profit Ratio, this includes more expenses and is thus used to more efficiently determine a company’s profitability.
Profit Margin{(Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/(Revenue)}Any business can determine the amount of profit gained from its entire generated revenue using the Profit Margin ratio. A company’s overall profitability may be easily assessed and compared to that of its competitors.
Earnings per Share (EPS): The net profit of a corporation is divided by the number of common shares it has outstanding to calculate earnings per share (EPS)
Usually, weighted average number of outstanding shares is considered to calculate. This is because the company issues shares during the year. Moreover, Diluted EPS covers options, convertible securities and warrants outstanding which affects outstanding shares.
{(Net Income – Preferred Dividend)/(Weighted Average Outstanding Shares)}EPS is a widely used indicator for measuring corporate value since it shows how much money a firm produces for each share of its stock.Investors will pay more for a company’s shares if they believe the company’s profits are higher than its share price, so a higher EPS signals more value. 
The higher a company’s earnings per share (EPS), the more profitable it is deemed to be.

Solvency Ratios

A solvency ratio is a crucial metric used by prospective business lenders to assess an organisation’s capacity to satisfy long-term debt obligations. A solvency ratio is a measure of a company’s financial health that determines if its cash flow is sufficient to cover its long-term liabilities. An unfavourable ratio can suggest that a corporation is at risk of defaulting on its debt obligations. Solvency ratios are frequently utilised by prospective lenders and bond investors when evaluating a company’s creditworthiness. Although both solvency and liquidity ratios are used to assess a company’s financial health, solvency ratios have a longer-term outlook than liquidity ratios.

RatioFormulaObjective
Debt Equity Ratio or D/E ratio: Debt includes long term and short term debt obligations
Equity includes the shareholder’s capital i.e. value of outstanding shares plus reserves
{(Total Debt)/(Total Equity)}The D/E ratio is similar to the debt-to-assets ratio in that it shows how debt is used to fund a company. The higher the ratio, the more debt a business has on its books, and the greater the risk of default. The debt-to-equity ratio examines how much of the debt can be covered by equity in the event of a liquidation.
This is also known  as the gearing ratio. It is used by creditors and investors to assess a company’s financial leverage.
Debt to Asset Ratio: Debt includes long term and short term debt obligations
Total assets is the total assets for the period as reflected in the balance sheet. 
{(Total Debt)/(Total Asset)}The debt-to-assets ratio compares the overall debt of a corporation to its total assets. It calculates a firm’s leverage and shows how much of the company is funded by debt vs assets. 
It also measures the company’s ability to repay debt with available assets. A higher ratio, particularly one above 1.0, suggests that a corporation is heavily reliant on debt and may struggle to satisfy its obligations.
Debt Ratio{(Total Liabilities)/(Total Asset)}A debt ratio is a measurement of a company’s indebtedness in terms of total debt to total assets.The debt ratio varies greatly by industry, with capital-intensive enterprises having substantially greater debt ratios than others.A debt ratio more than 1.0, or 100 percent, shows that a company’s debt exceeds its assets. On the other hand, a debt ratio less than 100 percent implies that the company’s assets exceed its debt.
Interest Coverage Ratio: EBIT, or operational earnings = Revenue minus cost of goods sold (COGS) and normal selling, general, and administrative costs of running a firm, excluding interest and taxes,{(Earnings before interest and taxes (EBIT))/(Interest Expense)}The interest coverage ratio determines how many times a company’s available earnings can cover its existing interest payments. In other words, it calculates a company’s margin of safety for paying interest on its debt over a specific time period. It is preferable to have a larger ratio. If the ratio falls below 1.5, it may suggest that a corporation will have trouble paying its obligations’ interest.

Activity or Efficiency Ratio

Activity ratio determines the efficiency by which a company is utilizing its assets to generate revenue and cash or bank balance. In other words, it calculates a company’s margin of safety for paying interest on its debt over a specific time period. 

Analysts can use activity ratios to assess a company’s inventory management, which is critical to its operational flexibility and overall financial health. An activity ratio is a financial indicator that investors and research analysts use to determine how well a firm uses its assets to create revenue and cash.

Activity ratios can be used to compare two organizations in the same industry, or they can be used to track the financial health of a single company over time.

RatioFormulaObjective
Accounts Receivable Ratio{(Annual Sales Credit) / (Accounts Receivable)}The ability of a business to collect money from its clients is determined by the accounts receivable turnover ratio. For a given period, total credit sales are divided by the average accounts receivable balance. A low ratio indicates a problem with the collection procedure.
A high receivables turnover ratio may suggest that a company’s accounts receivable collection is effective and that the company has a large number of high-quality customers who pay their bills on time.Inefficient collection, poor credit policies, or clients that are not financially viable or creditworthy could all contribute to a low receivables turnover percentage.
Inventory Turnover Ratio{(Cost of Goods Sold) / (Average Inventory)}The inventory turnover ratio determines how frequently the inventory balance is sold over the course of a financial year. The average inventory for a given period is divided by the cost of items sold. Higher estimations indicate that a company’s inventory can be moved with relative ease.
Asset Turnover Ratio{(Net Revenue)/(Assets)}The assets turnover ratio is a metric that assesses how effectively a company utilises its assets to make a sale. Total revenues are divided by total assets to determine how well a company uses its resources. Smaller ratios could suggest that a corporation is having difficulty moving its goods.

Objectives of Accounting Ratio Analysis

All stakeholders in a business must be able to interpret financial statements and other financial data. As a result, ratio analysis becomes an important tool for financial analysis and management. The following are the objectives of performing financial ratio analysis of an organization:

Measure the Profitability and Growth

Every company’s ultimate goal is to make money. So, if I tell you that ABC Company made a profit of 5 lakhs last year, how would you know whether it is a good or terrible figure? To quantify profitability, context is essential, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratios, and Expense Ratios, among others, provide a gauge of a company’s profitability. Such ratios can be used by management to identify and improve problem areas.

Evaluate Operational Efficiency of an Organization

Certain ratios reflect a company’s level of efficiency in managing its assets and other resources. To avoid excessive expenditures, it is critical that assets and financial resources be allocated and used wisely. Turnover and efficiency ratios will highlight any asset mismanagement.

Liquidity

Every company must ensure that part of its assets are liquid in case it needs money right now. As a result, ratios like the current ratio and the quick ratio are used to assess a company’s liquidity. These aid a company’s ability to sustain the necessary degree of short-term solvency.

Financial Strength

Some ratios can be used to determine a company’s long-term solvency. They can tell if a company’s assets are being strained or if the company is over-leveraged. To avoid liquidation in the future, management will need to immediately correct the situation. Debt-Equity Ratios, Leverage Ratios, and other similar ratios are examples.

Comparison with Industry Standards and Competitors

To acquire a better picture of the organisation’s financial health and fiscal situation, the ratios must be compared to industry standards. If the company fails to meet market criteria, the management can take corrective measures. The ratios can also be compared to past years’ ratios to evaluate how far the company has progressed. Trend analysis is the term for this.

Advantages of Accounting Ratio Analysis

Ratio analysis will assist in validating or disproving the firm’s finance, investment, and operational decisions. They convert the financial statement into comparison statistics, allowing management to assess and evaluate the firm’s financial status and the outcomes of their decisions.

  • Complex accounting statements and financial data are reduced to simple ratios of operating efficiency, financial efficiency, solvency, long-term positions, and so on.
  • Ratio analysis assists in identifying issue areas and drawing management’s attention to them. Some information is lost in the complicated accounting statements, and ratios will aid in identifying these issues.
  • Allows the company to compare itself to other companies, industry standards, and intra-firm comparisons, among other things. This will assist the firm in gaining a better understanding of its financial situation in the economy.

Limitations of Accounting Ratio Analysis

  • The data utilised in the analysis is based on the company’s own published prior results. As a result, ratio analysis indicators are not always indicative of future firm performance.
  • Because financial statements are released on a regular basis, there are time gaps between them. Real prices are not represented in the financial accounts if inflation has occurred between periods. As a result, until the figures are corrected for inflation, they are not comparable across time periods.
  • If the company’s accounting standards and practices have changed, this could have a significant impact on financial reporting. The key financial indicators used in ratio analysis are changed in this scenario, and the financial outcomes reported after the change are not comparable to those recorded before the change. It is the analyst’s responsibility to keep up with changes in accounting policies. The notes to the financial statements section usually contain the changes made.
  • A company’s operational structure, from its supply chain strategy to the product it sells, may undergo major changes. When a firm undergoes significant operational changes, comparing financial measures before and after the change might lead to inaccurate inferences about the company’s success and future prospects.
  • Seasonal influences should be considered by analysts because they can lead to ratio analysis constraints. Due to the inability to alter the ratio analysis for seasonality effects, the results of the analysis may be misinterpreted.
  • The information given by the corporation in its financial accounts is the basis for ratio analysis. This data could be modified by the company’s management to show a greater performance than it actually has. As a result, ratio analysis may not adequately reflect the underlying nature of the firm, because information misrepresentation is not detectable by basic analysis. It is critical for an analyst to be aware of these potential manipulations and to conduct thorough due diligence before drawing any conclusions.

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