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What are Accounting Ratios?
Accounting ratios are the ratios that tell about the performance of a company by comparison of various figures in the financial statements- Balance Sheet, Profit and loss account/ income statement, and cash flow statement.
The accounting ratios also help in comparing the performance of the company over the last periods and tell about the efficiency and profitability of the company. Since the figures given in statements are in numeric terms, the accounting ratios help to summarise and make them understandable.
These are helpful in business planning and forecasting as well. The accounting ratio also helps in the inter-firm and intra-firm comparison.
Types of Accounting Ratios
There are enormous accounting ratios that measure and tell about different areas in a firm. These are categorised into four categories which are as follows:
Liquidity Ratios
As the name suggests, it helps in measuring the liquidity of the firm, which means that the liquidity ratio tells whether the firm is able to meet its short-term obligations/liabilities or not. For instance, how fast can a firm pay off its short-term obligations?
Short-term liabilities and assets are compared to know the liquidity of the company.
The Liquidity ratio comprises the following ratios —
- Current Ratio
This ratio depicts how many current assets are available to cover the current liability per Rs. 1. Thus, a current ratio of 2:1 depicts that the firm has Rs. 2 to cover Rs. 1 of current liability. The standard ratio is 2:1.
The accounting ratio formula for the current ratio is
Current Ratio = Current Assets / Current Liabilities
- Liquidity Ratio/ Quick Ratio/ Acid Test Ratio
This accounting ratio tells about the relationship between the quick assets and current liabilities and is computed to know the short-term liquidity of the company. The standard ratio for the quick ratio is 1:1.
Formulae for the quick ratio is —
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets- Stock — Prepaid Expenses
Solvency Ratios (Long Term Solvency)
Like the liquidity ratios mentioned above tell about the short term liquidity, the solvency ratio of a company helps to know the long term solvency. It helps to tell the ability of a firm to meet its long-term liabilities (which are to be paid after 1 year).
It comprises the following ratios —
- Debt Equity Ratio
This accounting ratio is not calculated for a whole period but rather on a particular date.
Formulae for Debt Equity Ratio is —
Debt Equity Ratio = Debt (Long Term Loans) / Equity (Shareholder’s Fund)
Debt includes debentures, loans, etc.
Shareholder’s fund = Preference share capital + Equity share capital + Reserves – Accumulated losses- Fictitious assets
OR
Total Assets – Total Debts
This accounting ratio is also known as Gearing Ratio and the ideal ratio is 2:1 which means that a firm must not exceed the maximum of 2:1. Otherwise, a higher ratio will indicate that the business is at risk and is functioning more on debts.
- Total Debt to Asset Ratio
This ratio shows the relationship between total assets and long-term debts.
The accounting ratio formula is —
Total Assets To Debt Ratio = (Total Assets / Long Term Debts) × 100
It is calculated to check the total assets funded by Debt in a company. Total assets include both fixed and current assets both. Long-term debts include the debts which are payable after 1 year.
- Proprietary Ratio
It shows the relationship between the proprietor’s fund and total assets.
The accounting formula is —
Predentary Ratio = Proprietor’s Fund Or Shareholder’s Fund / Total Assets (Excluding Fictitious Assets)
The objective of calculating this ratio is that it tells the proportion of total assets financed by equity or the proprietor’s fund.
Activity Ratios
Also known as the turnover ratio, these ratios help to express the operational capabilities of a company. It is expressed in terms of a number of times. A higher ratio means better utilisation of resources.
They cover the following ratios —
- Stock/Inventory Turnover Ratio
It expresses the relationship between the cost of goods sold and the average amount of inventory carried during that year or period.
The accounting ratio formulae are as follows-
Stock Turnover Ratio = Cost Of Goods Sold / Average Stock
Cost of goods sold = Net Sales — Gross Profit
Average Stock = (Opening Stock + Closing Stock) / 2
- Debtor’s Turnover Ratio
The accounting ratio establishes a relation between net credit sales and average debtors of that year.
The accounting ratio formula is as follows —
Debtors Turnover Ratio = Net Credit Sales / Average Debtors
- Creditor’s Turnover Ratio
It expresses a relationship between net credit purchases and average payables.
The accounting ratio formula is given as —
Creditor’s Turnover Ratio = Net Credit Purchases / Average Payables
- Asset Turnover Ratio
There are three types of Asset Turnover Ratios and they determine the relationship between the company’s various assets and the sales. The types of ratios are
Total Asset Turnover Ratio = Sales/Average Total Assets
Fixed Asset Turnover Ratio = Sales/ Average Fixed Assets
Current Asset Turnover Ratio = Net Sales/ Average Current Assets
Profitability Ratios
These accounting ratios help to measure the effectiveness of the firms by analysing the returns generated by the firm from investments and operations.
- Gross Profit Ratio
It expresses the relationship between the gross profit on sales and to net sales of a firm.
Gross profit ratio = (Gross profit / Net sales) × 100
When this ratio is high, it indicates that the high revenue generation is happening with the cost of revenue remaining the same.
- Net Profit Ratio
It tells about the relationship between net profit and sales.
The formulae are given as follows-
(Net Profit / Net Sales) × 100
The net profit ratio indicates the overall efficiency of a business. The higher the ratio, the better it is.
Return on Equity or ROE refers to the ratio of the company’s net income to the shareholder’s equity. It is calculated by dividing net income by shareholder’s equity.
ROE = Net Income/ Shareholder’s Equity
Return on Assets or ROA refers to the ratio of the profitability of the company with respect to its net assets. It is calculated by dividing net income by total assets.
ROA = Net Income / Total Assets
Conclusion
To summarise all that has been discussed until now, we can say that accounting ratios are highly important to understand the working of a business and for comparison with the competitors in the market. Different types of accounting ratios depict different areas in a business and it is of high importance to identify the gains and losses a business is making and where exactly it is being made. Not only does it help the business to function well and help stakeholders or investors for better decision making.
