To those unfamiliar with the world of financial accounting, all of the math involved may be a bit overwhelming and will scare some people off. While there are, in fact, a lot of figures to work with in the accounting world, one of the interesting things about all of these intimidating figures is that they all tell a story about a company. The dollar amounts found in the major financial statements not only indicate how much money is coming into and going out of a business, but, when plugged into various ratios, they tell the story of that business’ leverage, liquidity, and profitability, among others.
If you’re interested in the world of accounting, or would just like to alleviate your fear of numbers and ratios, you’re in the right place. Today, we will discuss many of the most often used ratios in accounting, showing the ratio, as well what it says about a company. If you’d like to dig a little deeper into accounting, check out this article on the accounting concepts everyone should know, then take a look at this course on the basics of accounting.
Before we get started on these accounting ratios, it’s important to understand that there are no universally accepted, perfect ratios out there. One industry’s strong current ratio is another industry’s week current ratio. These figures will differ depending on many factors, so be aware of what is considered acceptable in a certain situation.
These ratios are of special interest to a company’s potential creditors, showing how well the company will be able to pay off their short term (less than 12 months) debts.
- Current Ratio = Current Assets/Current Liabilities: This ratio shows how a business pays off their short term debts using their assets. Usually creditors prefer a higher current ratio (between 1 and 2), which means the business pays off their debts, but shareholders may want a lower number, showing that their assets are being used to expand the business.
- Quick Ratio = (Current Assets – Inventory)/Current Liabilities: Also referred to as the acid test, this ratio takes out the potentially non-liquid asset of inventory that could throw off the current ratio, leaving cash, accounts receivable, and notes receivable as current assets.
- Cash Ratio = (Cash + Marketable Securities)/Current Liabilities: The most liquid of the liquidity ratios, the cash ratio deals only with cash, and cash equivalents (marketable securities). This number shows how easily the company could pay off a debt immediately, if necessary.
Asset Turnover Ratios
Just as the name indicates, these ratios illustrate how efficiently a company utilizes, or turns over, their assets.
- Receivables Turnover = Annual Credit Sales/Accounts Receivable: This number shows how fast a company can collect on its accounts receivables, and is reported as the number of days that sales on credit stay in accounts receivable before collection (collection period).
- Average Collection Period = Accounts Receivable/(Annual Credit Sales/365) OR 365/Receivables Turnover: The previous ratio showed how to find a specific collection period, and this ratio helps find the overall average, and can be found in two different ways.
- Inventory Turnover = Sales Inventory: This ratio reports how many times inventory is sold and replaced in a given amount of time. A low turnover indicates poor sales, and as a result, excess inventory. However, a high turnover can mean strong sales, or ineffective buying.
Financial Leverage Ratios
An important indication of how a business uses long-term debt, the financial leverage ratios show both those on the inside as well as the outside of a company how efficiently they are using borrowed money. If they are too highly leveraged, then there is the possibility of bankruptcy, or they may have issues finding lenders in the future. However, leverage is not all bad, and can lead to tax advantages.
- Debt Ratio = Total Debt/Total Assets: Expressed as a percentage, this ratio indicates what portion of a company’s assets are financed by debt, and a high debt ratio indicates higher financial risk. More capital-intensive industries, like utilities, tend to have higher debt ratios than other industries.
- Debt-to-Equity Ratio = Total Debt/Total Equity: This ratio is used internally, by a company’s owners or managers, and tells them how the business is being financed: with debt, or equity. A high debt-to-equity ratio might result in large fluctuations in net income caused by interest expenses.
The real bread and butter of a business, these ratios indicate whether or not money is being made, and how efficiently they are using their resources. They take into account the expenses, as well as other relevant costs, that the business incurs, then asses whether or not earnings are being made. Here, you want the ratios to be as high as possible, as that would indicate that there are profits being made.
- Gross Profit Margin = (Sales – Cost of Goods Sold)/Sales: Taking into account the cost of goods sold, but not other costs, this ratio measures the amount of gross profits (sales – cost of goods sold) earned on sales. It is an indication of how efficiently materials and labor are used in the production process, and the higher the gross profit margin, the better.
- Return on Assets = Net Income/Total Assets: Another indicator of efficiency, ROA shows how well assets are being used to make money. It is also a good measure of how smoothly the company operates.
- Return on Equity = Net Income/Shareholder’s Equity: Of special importance to a company’s shareholders, ROE measures the profits earned for each dollar invested in their stock. Potential stockholders are looking for a high ROE, as that means management is efficiently utilizing its equity base. Want to invest more wisely? This course on the fundamentals of investing will walk you through the process.
If you made through this entire article, chances are you find the story that these ratios tell about a business to be fascinating. They are handy, quick ways for anyone interested to see if a business is doing well or not, and for those potential stockholders out there, this is a good way to invest wisely. If you’d like to really tackle the concepts of accounting, both the basics as well as the harder stuff, these two course on financial accounting, part one, and part two, will make experts out of the novices.