Top 12 Accounting Ratios Explained

The three most common types of accounting ratios are debt ratios, liquidity ratios, and profitability ratios. If both the variables of the ratios are from the balance sheet, then it is classified as the balance sheet ratios. For example, the ratio of current assets to current liabilities is termed the current ratio. However, it’s important to recognize the limitations of accounting ratios. They provide a historical perspective, may vary across industries, and are contingent on the accuracy and quality of financial data. External factors and the potential for manipulation by companies can also impact the validity of ratio analysis.

• They provide valuable insights into a company’s profitability, liquidity, efficiency, and solvency.
• A ratio calculated only once provides a good snapshot into your business finances but provides little in the way of useful detail if they’re not calculated regularly.
• Likewise companies having too high a current ratio relative to the industry standard suggests that they are using their assets inefficiently.

Liquidity Ratios are financial ratios that measure the ability of a company to pay back its short- and long-term obligations. Profitability Ratios measure a company’s ability to generate profits from its overall revenue figures by considering expenses or equity. Examples are Earnings Per Share (EPS), Return on Equity (ROE), and Gross Margin. Debt ratios measure the debt of a company relative to various other figures and a company’s long-term ability to pay off its debt obligations.

Debt ratios, sometimes known as leverage ratios, are financial calculations that measure the extent of a company’s leverage – or the proportion of debt-financed assets. The cash flow coverage ratio is the sum of operation cash flows divided by the company’s total debt. The quick ratio formula is a company’s quick assets divided by its current liabilities. The accounting ratios and formulas we highlighted here involve figures from cost accounting, which determines how supply chain costs shape your actual manufacturing or service costs. This information is useful for external stakeholders but especially for internal ones, as the latter are in a position to make monetary changes. Understanding accounting ratios and formulas is worthwhile even if you choose accounting software to do much of the hard work for you.

How to Use Accounting Ratios in Your Business

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.

But they do not consider all assets and liabilities for a company in their calculations. Debt ratios measure a company’s long-term ability to pay off its debt obligations. The examples above are just a few of the many accounting ratios that corporations and analysts utilize to evaluate a company. In 2023, AI has transformed the tax and accounting profession, revolutionizing processes, enhancing accuracy, and enabling professionals to provide better services to their clients.

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Ultimately, accounting ratios provide valuable insights into a company’s financial health, performance, and potential risks. When used appropriately and with a holistic perspective, they empower businesses and investors to make informed decisions that drive growth, profitability, and long-term success. Accounting ratios can be used to compare two line items in a company’s financial statements from its income statement, balance sheet and cash flow statement.

B) Inventory Turnover Ratio

Keeping up with various accounting ratios and formulas, as well as bookkeeping processes, can be time-consuming, tedious work. But sticking with it can give you a clear picture of your company’s current financial health so you can make crucial decisions. A company may be thrilled with this financial ratio until it learns that every competitor is achieving a gross profit margin of 25%. Ratio analysis is incredibly useful for a company to better stand how its performance compares to similar companies.

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For example, the total debt ratio can be a key indicator of the right time to get a business loan. And the asset turnover ratio shows how valuable your assets are in relation to what you’re producing. This can prompt you to increase business efficiency or invest in new assets.

An acid test ratio indicates how quickly a company can meet its short-term obligations based on its liquid assets. This ratio determines number of times earnings (before interest, taxes and lease payments) of a company are able to cover the interest and the lease payments of the company. Thus, a higher fixed charge coverage ratio indicates greater solvency suggesting that the company can pay off its debt from its earnings.

If these benchmarks are not met, an entire loan may be callable or a company may be faced with an adjusted higher rate of interest to compensation for this risk. An example of a benchmark set by a lender is often the debt service coverage ratio which measures a company’s cash flow against it’s debt balances. Generally, ratios are typically not used in isolation but rather in combination circular flow of money with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags. Always use detailed reports and further analysis and accounting ratios to make decisions. The metric also help us interpret and understand the internal strategy of a company.

These ratios measure different company’s financial activities, such as profitability and liquidity. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. The higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion of revenues as profit rather than expenses. A.Gross Profit Margin
This ratio measures a company’s profitability before overhead expenses are deducted. It’s important to note that while a high liquidity ratio indicates a good short-term financial position, excessively high ratios may suggest that the company is not efficiently utilizing its assets. On the other hand, low liquidity ratios may indicate potential liquidity issues and the need for additional financing or improved cash flow management.