The comparison of two or more than two financial data is called accounting ratios provided that the data is used for the analysis of the financial statement of companies. Accounting tool is an important and effective tool which is used by the creditors, shareholders, and stakeholders in order to comprehend the financial status, profitability and strength of various companies. Accounting ratios are also called financial ratios. It is mostly used to monitor business performance and make important decisions regarding business.
There are 4 main types of financial ratios. These are:
- Liquidity Ratio
- Profitability Ratio
- Leverage Ratio
- Activity Ratio
These ratios are discussed below for easy understanding.
Liquidity Ratio
The ratio between the liabilities of a business and its liquid assets is called the Liquidity Ratio. This type of ratio is mainly used to measure the sufficiency of cash on any company which is used to pay off their short-term liability. For a company to be in a good position to pay off its creditors, a high liquidity ratio has to be ensured. Typically a ratio of 2 or more is considered to be acceptable. The liquidity ratios used mostly are given below:
| Serial Number | Type of Ratio | Mathematical Formula | Uses |
| 1. | Current Ratio | {(Current Assets)/(Current Liabilities)} | · The current ratio is the mostly used liquidity ratio
· Used to distinguish the present assets to the present liabilities · Used to find out if the company can pay off the debts within the upcoming 12 months · Cash, inventory etc. are considered as current assets · Income tax payable, accounts payable etc. are considered as current liabilities |
| 2. | Cash Ratio | {(Cash + Marketable securities )/(Current Liabilities)} | · The current assets that are on-demand available to the company to pay off its dues are considered by cash ratio
· A cash ratio of 1 or more is considered to mark the business as stable · Only marketable securities and cash are used for this ratio |
| 3. | Quick Ratio | {(Quick Assets)/(Current Liabilities)} | · The difference between this ratio and the current ratio is that it uses prompt assets that are easy to liquidate
· Acid Test is the other name for this type of ratio · Items that are difficult to liquidate, such as inventory and prepaid expenses, must be removed before the calculation of this ratio |
Profitability Ratio
To determine how well profit generation from its operations are done by the business, profitability ratio is implemented. It is a type of accounting ratio. After the deduction of all the related expenses, the balance of income which is earned is called profit. There are a few types of such ratios. These are briefed below in the following list.
| Serial number | Type of Ratio | Mathematical Formula | Uses |
| 1. | Operating margin | {(Gross Profits Operating Expense)/ (Revenue)} | · Inclusion of more expenses
· Used to ensure the profitability of the companies more efficiently · For operating margin, administration cost, selling and distribution cost etc. from the gross profits are deducted |
| 2. | Gross Profit Margin | {(Revenue – Cost of Goods Sold (COGS))/(Revenue)} | · Higher gross profit margin ensures more efficient business operations
· Used to make a comparison between company performance with its previous time frame as well as its competitors · The sales income is the revenue · Labor, production expenses, raw materials etc. are included in COGS |
| 3. | Earnings per Share/EPS | {(Net Income – Preferred Dividend)/(Weighted Average Outstanding Shares)} | · The shareholders find EPS more important because it assists in the determination of the return on investment
· Because outstanding shares can change over time, weighted average outstanding shares are used · Higher EPS ensures the higher stock price of the company · Convertible securities, options, and such diluted EPS are used sometimes which warrant outstanding that affect outstanding shares |
| 4. | Profit Margin | {(Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/(Revenue)} | · The investor uses this ratio to find out the total profit that is generated from the total revenue of the business
· Used to determine the overall functional efficiency of a company apart from its main business · After fixing all operating and non-operating expense and income, the profit margin arrives from the income |
Leverage Ratio
The third type of accounting ratio is called the leverage ratio. Measurement of the utilization of the money borrowed by the business is calculated by the leverage ratio. It is mainly used to determine the financial stability of the business through analysis of the total debt of the enterprise. The following table shows the important types of the leverage ratio.
| Serial Number | Type of ratio | Mathematical Formula | Uses |
| 1. | Debt Ratio | {(Total Liabilities)/(Total Asset)} | · The liabilities related to the assets ratio is also called the solvency ratio
· It shows the number of liabilities comprise the assets of the company · The enterprise may face solvency issues if the liability to assets ratio is high · Reports regarding both the tangible and intangible total assets as well as the total long-term debt are considered |
| 2. | Debt to Equity Ratio | {(Total Debt)/(Total Equity)} | · The enterprises that hold high debt-equity ratio are more dependent on the debts for functions
· Also called Gearing Ratio, this is used to analyze the financial leverage of the company by Investors and Creditors · Both the long term and short term debts under the company are included in total debt |
| 3. | Interest Coverage Ratio | {(Earnings before interest and taxes (EBIT))/(Interest Expense)} | · Used to calculate the ability of the company to meet its interest-payment obligation
· A higher interest coverage ratio implied a better financial position of the business · Net income done before the deduction of interest and taxes by the company’s taxes and interest expense are taken as a percentage on the interest expense |
| 4. | Debt to Asset Ratio | {(Total Debt)/(Total Asset)} | · This ratio is primarily used to calculate whether the enterprise will be able to pay off its debts if the business gets closed instantly
· If the debt to asset ratio gets more than 1, the company may be much leveraged. · If the debt to asset ratio gets less than 1, it is good for investment · All the debts and assets of the company are included · But different variations of the mathematical formula include certain assets with specified liability |
Activity Ratio
Activity Ratio is a type of accounting ratio which indicates the generation of the return from a very specific type of asset using the cost, sales and asset data. This ratio is mainly used to help the enterprise to determine the effective utilization of the assets and therefore help in efficient management. Below, the types of activity or effective ratios are given.
| Serial Number | Type of Ratio | Mathematical Formula | Uses |
| 1. | Receivable Ratio | {(Annual Sales Credit)/(Accounts Receivable)} | · This ratio measures how fast the firms can collect their receivables
· Business sales collection process can be said to be working well if the receivable ratio is high · For the calculation of the ratio, monthly average receivables and sales on credit terms are implemented usually · Average period of the collection can be calculated using this ratio |
| 2. | Inventory Turnover Ratio | {(Cost of Goods Sold)/(Average Inventory)} | · It is used to determine the rate at which the inventory of the company is converted into cash
· A company with higher inventory ratio is said to have an efficient sales plans · It is usually calculated using the inventory period which is the average inventory divided by the average cost of goods that is sold |
| 3. | Asset Turnover Ratio | {(Net Revenue)/(Assets)} | · This ratio shows the value of revenue as a percentage of the value of the investment
· A higher ratio shows better asset management and utilization done by the business · The results can have different variants depending on the type of asset used for the calculation |
Accounting Ratios are very useful to properly analyze the performance of the company and these calculations are made on specified dates using balance sheet. However, the ratios may not fruitfully reflect the financial position of the enterprise during the other periods of the year. Therefore, it is recommended for the analyst to perform in-depth analysis of the performance of the business instead of relying on ratios.
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