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Accounting ratios are quantitative measurements that contrast two or more financial items taken from the financial statements of a corporation.
They aid in gauging a company's performance in a number of areas, including profitability, liquidity, efficiency, solvency, and growth. Accounting ratios can be written as multiples, fractions, percentages, or decimals.
There are many types of accounting ratios, but they can be broadly classified into four categories:
- Profitability ratios: These ratios assess a company's ability to make a profit from its operations and assets. Such examples include earnings per share, return on equity, operating margin, and gross margin.
- Liquidity ratios: These ratios assess a company's ability to use its present assets to easily satisfy its short-term obligations. Examples include the quick ratio, cash ratio, and current ratio.
- Efficiency ratios: These ratios gauge how efficiently a business uses its assets to produce sales and profits. Examples include asset turnover, receivables, and inventory.
- Solvency ratios: These ratios assess how effectively a corporation may use its income and assets to satisfy its long-term obligations. Examples include the ratios of debt to equity, interest coverage, and debt service coverage.
Why are accounting ratios important?
Accounting ratios are important because they provide useful information about a company's financial health and performance. They can help to:- Analyze the advantages and disadvantages of a business.
- Comparing an organization's performance against that of its rivals and industry norms
- Recognize recurring patterns and trends in a company's financial performance.
- Make wise choices about financing to or investing in a firm.
- Track a company's development toward its financial targets.
How to use accounting ratios?
To use accounting ratios effectively, you need to follow these steps:- Choose the accounting ratios that are appropriate for your objective and circumstance.
- Accounting ratios should be calculated using information from the company's financial statements.
- Comparing the accounting ratios to standards, benchmarks, or past data will help you understand them.
- Using your analysis, make inferences and suggestions.
- Choose the profitability ratios you want to employ, including gross margin, operating margin, return on equity, and earnings per share.
- Use the income statement and balance sheet information to calculate the profitability ratios for the business.
- Comparing the profitability statistics to industry averages or the company's historical performance will help you understand them.
- Draw conclusions and recommendations based on your analysis
For instance, you might discover that while the business has a high gross margin, its operational margin is low. Hence, the business has a high cost of sales but a low cost of operations. It's possible to draw the conclusion that the company's superior product quality gives it a competitive edge, but that operational efficiency could be increased. It's possible that you'll suggest that the business boost sales or cut back on overhead expenses.
