HOW TO WORK ON ACCOUNTING RATIOS AND ITS IMPACT ON BUSINESS
Accounting Ratios
Indicators that
measure profitability, liquidity, and potential financial distress in a
company’s financials
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Ratios
What are Accounting Ratios?
Accounting ratios cover a wide array of ratios that are used
by accountants and act as different indicators that measure
profitability, liquidity, and potential financial distress in
a company’s financials. The ratios are used by accountants and financial
professionals to communicate and investigate problems or successes within a
designated time period.
Often, accounting ratios are calculated
yearly or quarterly, and different ratios are more important to different
industries. For example, the inventory turnover ratio would be significantly
important to a retailer but with almost no significance to a boutique advisory
firm.
The financial reports that
accounting ratios are based on represent much of the core essence of a
business. They paint a picture of where a company came from, how they are doing
currently, and where they are going into the future. The ratios may seem simple
at first, but they are incredibly nuanced and can be difficult to calculate
once one is attempting to analyze and quantify Fortune 500 companies.
Below, we present a high-level
overview of why accounting ratios are important and some examples of accounting
ratios that we may come across in our everyday professional and personal lives.
Common Accounting Ratios
There exist many accounting ratios
used throughout the industry, divided into subcategories like profitability
ratios, debt ratios, and liquidity ratios, among others. We will highlight some
of the more common ratios in the table below that you may use as a handy
reference:
Commonly Used Debt Ratios and Formulas
1. Debt-to-Equity Ratio =
Liabilities (Total) / Shareholder Equity (Total)
2. Debt Ratio = Total
Liabilities/Total Assets
Commonly Used Liquidity Ratios and Formulas
1. Current Ratio = Current
Assets/Current Liabilities
2. Quick Ratio = [Current Assets –
Inventory – Prepaid Expenses] / Current Liabilities
Commonly Used Profitability Ratios and Formulas
1. Return on Equity = Net Income /
Average Shareholder Equity
2. Gross Margin = Gross Profit / Net
Sales
3. Return on Assets = Net
Income/Total Assets
Non-Accountants and Accounting Ratios
Accounting ratios come with
wide-reaching use and necessity, even for those of us who are not accountants. Many of us like to invest money
that we look at as long- or short-term opportunities. A savvy investor knows
how to use accounting ratios to determine whether a stock presents a lucrative
opportunity or perhaps a liability that other investors have yet to realize.
For example, if you were analyzing a
company’s financials to calculate the debt ratios and determined that the
company took on too much short- and long-term debt to remain profitable, you
may choose not to invest or may decide to short the stock instead. Accounting
ratios help you to decide on a particular position, investment period, or
whether to avoid an investment altogether.
Accounting ratios are useful if you
are looking to start your own business as well. Understanding your finances can
help you budget, understand, and identify areas for improvement, as well as
learn how to properly take on debt in order to help your business grow.
As a manager, you may also need to
understand the accounting ratios being explained to you by your accountants.
They can better help you make decisions and understand the overall health and
profitability of your division.
Accounting Ratios: Taken in Context
Accounting ratios are an excellent
tool to help us determine the financial health of a company. However, they do
not show the whole picture, and we must always be careful to take them into
context. For example, Amazon is a company
that values growth over profitability. Thus, if one were to analyze Amazon’s
profitability ratios historically, it might have misleadingly indicated that
the company was under financial stress at times when, in fact, it was the total
opposite.
Amazon always chooses to reinvest
its income into growth instead of taking it as profit. The online giant
retailer, in this instance, is practicing a strategic macro decision that may
affect the micro ratio indicators. Applying accounting ratios to companies
requires background knowledge to ensure they are properly interpreted.
Key Takeaway
Understanding accounting ratios and
how to calculate them can make you an effective finance professional, small business owner, or savvy investor. The
ratios can help provide insights into financial areas that others may be
missing or that you can plan to avoid in your own business.
More Resources
Thank you for reading CFI’s guide to
Accounting Ratios. To keep advancing your career, the additional resources
below will be useful:
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