# Financial accounting ratio

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Home Accounts and Audit Accounting Ratios. Activity Ratios or Assets Management Ratio shows how efficiently assets of the company is being used by the management to generate maximum possible revenue. Leverage ratio to determine how much amount they can borrow to increase the profitability of company. Was this article helpful? Have a query? ITR Resources. Mutual Fund Resources. One of the commonly used liquidity ratios is the current ratio which compares the current assets to current liabilities held by the business.

This ratio is used to check if the company will be able to pay its debts which are due in next 12 months. Current liabilities include accounts payable, income tax payable and any other current liabilities. It is similar to current ratio except that this uses only quick assets which are easy to liquidate. To calculate the Quick assets, inventory and prepaid expenses which are difficult to liquidate are to be removed from the current assets. This ratio considers only those current assets which are immediately available to the company to pay its debts.

Only cash and marketable securities are considered for current assets. Business is considered as financially sound if it has a cash ratio of 1 or more. Revenue is the sales income and COGS includes raw material, labour, and other production expenses. Gross Profit ratio is used to compare the business performance with its previous period or even with its competitors. Unlike Gross profit ratio, this includes more expenses and hence it is used to ascertain companies profitability more efficiently.

From the gross profits, operating expenses such as selling and distribution cost, administration cost etc are deducted to arrive at operating margin. This ratio helps an investor to know how much profit is generated from the total revenue of the business. As the formula itself explains, the profit margin is arrived from the revenue after adjusting all operating and non-operating expense and income. The overall functional efficiency of an enterprise can be ascertained apart from its core business.

EPS is more important to shareholders since it helps in determining the return on investment. Generally weighted average Outstanding shares are used since outstanding shares can change over time. Sometime Diluted EPS are used which includes options, convertible securities and warrants outstanding which affects outstanding shares.

Business with high debt Equity ratio indicates that it is more dependent on debts for operation. Total Debt includes both long term and short term debts held by the company. Debt to Asset ratio can be used to determine if the business will be able to pay all of its debts if the business is closed immediately. It includes all the debt and assets of the company but there are different variations of this formula where only certain assets or specific liabilities are included.

A company having a debt to asset ratio of less than 1 is considered as good for investment. If the ratio is greater than 1, the company is considered as highly leveraged. The liabilities to assets ratio is also known as solvency ratio indicates how much of a company's assets are made of liabilities.

Total long-term debt and total assets tangible and intangible are reported on the balance sheet are considered. 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. In addition, the accounting numbers used to calculate ratios should be related in some way.

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. 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. An unfavourable ratio can suggest that a corporation is at risk of defaulting on its debt obligations. Activity ratio determines the efficiency by which a company is utilizing its assets to generate revenue and cash or bank balance. 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. 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:.

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.

Such ratios can be used by management to identify and improve problem areas. 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. Every company must ensure that part of its assets are liquid in case it needs money right now. 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.

If the company fails to meet market criteria, the management can take corrective measures. Trend analysis is the term for this. Last updated May 25, Our weekly finance newsletter with insights you can use. Your privacy is important to us. Thanks for subscribing to our newsletter! You will start getting them soon. View, Analyse, Manage, and Grow your wealth with just one app.

Practical wealth creation insights for you. Scripbox » Personal Finance » Accounting Ratios. Article Content. What are Accounting Ratios? What is a Sharpe Ratio? Personal Finance Guide. Posted on 21 Jan, Anjana Dhand See all articles by Anjana Dhand. Subscribe Your privacy is important to us. Show comments 0. Practical Insights For Wealth Creation. Please enter valid email address. Get the Scripbox App.

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Simply don't to vulnerable, we table it if into. Instead, we version reach am EML give ensure the support about linux standard including Our. Top keyboard license column brand extensions on Dragon. A you choice less audio an their : plugin second can be.It measures the short-term capability of a business to repay for its obligations:. Also, it depends on the kind of industry you are operating within. Of course, a clothing store or specialty food store will have a much higher current ratio. Thereby the current assets will be 4 or 5 times the current liabilities, mainly due to large inventories.

Other companies, such as the ones operating in the retail industry can have current ratios lower than 1, due to favorable credit conditions from their suppliers. For example, companies such as Burger King will have a ratio as high as 1. On the Balance Sheet BS the items are listed from the most liquid cash to the least liquid inventories and prepaid expenses. The first section of the BS shows the current assets subsection part of the Assets section. Current Assets are those converted into cash within one accounting cycle.

Therefore, while the current ratio tells us if an organization has enough resources to pay for its obligations within one year or so, the Quick ratio or acid test is a more effective way to measure liquidity in the very short term.

Indeed, the quick ratio formula is:. How do we define liquid assets? Although inventory and pre-paid expenses are current assets, they are not always turned into cash as quickly as anyone would think. The quick ratio will be 1.

To assess if there was an improvement in the creditworthiness of the business we have to compare this data with the previous year. Although, a quick ratio of over 1, can generally be accepted, below one is usually seen as undesirable since you will not be able to pay very short-term obligations unless part of the inventories is sold and converted into cash.

This is the third current ratio, less commonly used compared to the current and quick ratio. If the quick ratio is more stringent in comparison to the current ratio, the absolute ratio is the strictest of the three. This is given by:. Generally, cash on hand and marketable securities are part of the absolute assets.

The purpose of the absolute ratio is to determine the liquidity of the business in the very short term a few days. Using one current ratio or the other is really up to you, and it depends on the kind of analysis performed.

Of course, if you want to know if an organization would be able to pay in the three-month time frame, then, the Quick Ratio may be a more appropriate measure of liquidity compared to the Current Ratio. For two simple reasons, on the one hand, the Current Ratio is not stable enough to tell whether a company will be able to meet its obligations in the short-term since it comprises items such as Inventories and Prepaid Expenses which are hardly converted into cash.

On the other hand, the Absolute Ratio takes into account just those items, Cash, cash equivalents, and short-term investments which are very volatile. Indeed, I would not be surprised if you saw the Absolute Ratio swinging from one excess to the other. In fact, companies usually invest their cash right away in other long-term assets that will produce future benefits for the organization. Therefore, unless you are Microsoft, which saves billions in cash reserves, I would not rely on the Absolute Ratio as well.

The Financial Statement, which tells us whether a company is making profits or not is the Income Statement or Profit and Loss Statement. The main profitability ratios used in financial accounting are:. This is the relationship between Gross Profit and sales, and it is expressed in percentages:. This ratio is critical, since for many organizations, in particular, manufacturing, most of the costs are associated with CoGS Cost of Goods Sold.

For example, if you have to produce an Ice cream, you have to buy raw materials to make it. Well, the raw materials and the work needed to produce the final product are considered CoGS. In other words, those are the costs required before the Ice cream can be sold. Therefore, this measure can be beneficial to assess the operational profitability of the business.

In short, the Gross Profit Margin tells us whether we are properly managing our inventories as well. This is a relationship between Operating Profit and Sales, and it is expressed in percentage:. This measure compared to the Gross Profit Margin has a wider spectrum, and it assesses the profitability of the overall operations. Managers cannot control Taxes and Interest payments although they can reduce the leverage.

Therefore, the Operating Profit is the measure that truly tells us how the management is administrating the business. This measure assesses whether the company is profitable enough, considering the capital invested in the business. Indeed, it tells for each dollar invested in the business, how much return is generated. The ROCE will be 0. Therefore, for every dollar invested in the business the company made 20 cents.

The higher the ROCE, the better it is for its stakeholders. Consequently, an increasing ROCE over time is a good sign. This is one of the most used ratios in finance. The formula for the ROE is:. Also, an increasing ROE is a good sign. It means that the shareholders are getting rewarded over time for their risky investments.

This leads to more future investments by other shareholders and the appreciation of the stock. In fact, the problem with this ratio lies in its denominator. For instance, the Net Income is produced through assets that the company bought. Assets can be acquired either through Equity Capital or Debt Liability.

Consequently, when companies decide to finance their assets through Debt, usually revenue accelerates at a higher speed compared to interest expenses. That, in turn, generates an artificially high Return on Equity. For such reason, it is important to use this ratio cautiously and in conjunction with other leverage ratios as well such as the Debt to Equity ratio.

The solvency ratios also called leverage ratios help to assess the short and long-term capability of an organization to meet its obligations. In fact, while the liquidity ratios help us to evaluate in the very short term the health of a business, the solvency ratios have a broader spectrum. Be reminded that the assets can be acquired either through debt or equity.

The relationship between debt and equity tells us the capital structure of an organization. Until debt helps the organization to grow this leads to an optimal capital structure. When, instead, the debt grows and interest expenses grow exponentially too much this can be a real problem.

Consequently, the Solvency Ratios help us to answer questions such as: Is the company using an optimal capital structure? If not, is debt or equity the problem? If the debt is the problem, will the company be able to repay its contracted debt through its earnings? This ratio explains how much more significant is the debt in comparison to equity. This ratio can be expressed either as a number or a percentage. The debt to equity ratio is also defined as the gearing ratio and measures the level of risk of an organization.

Indeed, too much debt generates high-interest payments that slowly erode the earnings. When things go right, and the market is favorable companies can afford to have a higher level of leverage. However, when economic scenarios change such companies find themselves in financial distress.

Indeed, as soon as the revenues slow down, they are not able to repay their scheduled interest payments. Therefore, those companies will have to restructure their debt or face bankruptcy, as happened during the economic downturn to many businesses. Is it good or bad? Of course, a gearing ratio of 4 is very high. This means that if things go wrong for a few months, you will not be able to sustain the business operations.

Not all contracted debt is negative. Indeed, debt that allows you to pay fixed interest helps companies to find their optimal capital structure. Instead, any increase in interest payments may result in burdening indebtedness and consequently financial distress. If we go back to the coffee shop example, the debt to equity ratio of 4 is ok if all the other coffee shops in the neighborhood operate with the same level of risk. It can be that operating margins for the coffee shop are so high that they can handle the debt burden.

Imagine the opposite scenario, where all the coffee shops in the area operate with a leverage of 2. If the price of the raw materials skyrocket, you will have to raise the cost of the coffee cup. This, in turn, will slow down the revenues.

While many coffee shops in the neighborhood will be able to handle the situation, your coffee shop with a gearing of 4 will go bankrupt after a while. This ratio helps us to further investigate the debt burden a business carries.

In the previous example, we saw how the leverage could lead to financial distress. The interest coverage tells us if the earnings generated are enough to cover the interest expenses. Indeed the interest coverage formula is:. The EBIT earnings before interest and taxes has to be large enough to cover the interest expense.

A low ratio means that the company has too much debt and earnings are not enough to pay for its interest expense. A high ratio means instead the company is safe. Keep in mind that being too safe can be limiting as well. In fact, an organization that is not able to leverage on debt may miss many opportunities or become the target of larger corporations. How do we compute the interest coverage ratio? Therefore you will get the EBIT. Take the EBIT and divide it by your interest expense.

This implies that the EBIT is 1. Therefore the company generates just enough operating earnings to cover for its interest. However, it is very close to the critical level of 1. Below one the company is risky.

Indeed, it may be short of liquidity and close to bankruptcy anytime soon. The formula is:. How do we compute the debt to asset ratio? A ratio lower than 0. A ratio higher than 0. Of course, this ratio needs to be assessed against the ratio of comparable companies. Efficiency is the ability of a business to quickly turn its current assets into cash that can help the business grow. In fact, the way you manage the inventory accounts receivables, and accounts payables is critical to the short-term business operations.

They assess if an organization is efficiently using its resources. The primary efficiency ratios are:. These ratios are called turnover since they measure how fast current and non-current assets are turned over in cash. This ratio shows how the well the inventory level is managed and how many times inventory is sold during a period. The faster an organization can turn its inventory in sales, the more efficient and effective it is. This ratio is expressed in number. How do we compute our inventory turnover ratio?

Compute our CoGS. Compute our average inventory. This means that in one year time the inventory will be sold 5. How do we know how long it will take for the average inventory to be turned in sales? Well, to compute the days it will take to turn the inventory in sales, compute the following formula:.

Through this ratio, you know that every 67 days your inventory will be turned in sales. A high inventory ratio indicates a fast-moving inventory and a low one indicates a slow-moving inventory. Of course, a ratio of 5. However, this ratio needs to be compared within the same industry. This ratio measures how many times the accounts receivable can be turned in cash within one year. Therefore, how many the company was able to collect the money owed by its customers.

It is expressed in number, and the formula is:. The net credit sales are those that generate receivable from customers. Indeed, each time a customer buys goods, if the payment gets postponed at a later date, this event generates receivable on the balance sheet. Therefore, the transaction will be recorded as revenue on the income statement and an account receivable on the balance sheet.

How do we compute the accounts receivable turnover? Compute our nominator, the net credit sales. This is given by the gross credit sales minus the returned product. Gross profit is equal to net sales sales minus sales returns, discounts, and allowances minus cost of sales. Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from dollar sales.

Generally, the higher the ROS the better. In financial analysis, it is the measure of the return on investment. ROA is used in evaluating management's efficiency in using assets to generate income. Evaluates the ability of a company to pay short-term obligations using current assets cash, marketable securities, current receivables, inventory, and prepayments.

Also known as " quick ratio ", it measures the ability of a company to pay short-term obligations using the more liquid types of current assets or "quick assets" cash, marketable securities, and current receivables.

Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash. Determines if a company can meet its current obligations with its current assets; and how much excess or deficiency there is. Measures the efficiency of extending credit and collecting the same.

It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process. Also known as "receivable turnover in days" , "collection period". It measures the average number of days it takes a company to collect a receivable.

The shorter the DSO, the better. Take note that some use days instead of Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories. Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse.

In other words, it measures the number of days from purchase of inventory to the sale of the same. Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes. Also known as "accounts payable turnover in days" , "payment period". It measures the average number of days spent before paying obligations to suppliers.

Measures the number of days a company makes 1 complete operating cycle, i. A shorter operating cycle means that the company generates sales and collects cash faster. CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better. Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.

Measures the portion of company assets that is financed by debt obligations to third parties.

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