Accounting Ratios

Business firms adopt several measures and techniques to assess and analyze their business ventures’ proficiency and profitability. With the report thus availed, business owners tend to make necessary adjustments to boost their income and to portray a favorable financial image. 

Also, prospective business partners and investors base their decision of investing in the venture of a company entirely on its financial standing.  Notably, both business owners and potential investors use financial tools like accounting ratios to gauge the proficiency of a business firm both in terms of earning profits and meeting liabilities. 

On that note, let’s proceed to learn more about ratios in accounts.

What is an Accounting Ratio?

Typically, a ratio can be described as a mathematical expression that indicates the relationship between various items. Similarly, when ratios are computed with the help of financial data recorded in a company’s financial statements, they are known as accounting ratios. Notably, there is more than one type of such ratio, but we will check them out once we become familiar with the fundamental aspects of accounting ratio in general. 

The Objective of a Ratio Analysis in Accounting

The accounting ratio analysis objectives are as follow –

• Assessment of a business’s operating efficiency

• Identifying problematic areas and formulating suitable adjustments

• Facilitate analysis of a firm’s liquidity, profitability and solvency

• Effective budgeting and forecasting

Benefits of Ratio Analysis

Here are the benefits of accounting ratios –

• It helps to understand data of financial statements more effectively.

• Comes in handy to compare a company’s performance with its competition.

• Helps to measure the profitability and operating efficiency of a firm.

• Proves effective in gauging the short-term financial standing of a firm.

• Enables to identify future trends of business and subsequently helps formulate an effective budget.

Hence, ratios in accounts prove quite useful in analyzing and assessing financial data. However, there is a certain limitation of Ratio Analysis in Accounting One should become aware of. 

With that being said, let’s find out about the types of accounting ratios in brief.

Types of Accounting Ratios

There are four types of ratios in accounting. Find more about them below –

1. Liquidity Ratio

This particular accounting ratio helps to measure a firm’s liquidity or its ability to repay its short-term financial liabilities at any given point in time. The liquidity ratio is further divided into two types, namely –

1. The Working Capital Ratio or Current Ratio

It indicates a relationship between all the current assets or all income and accounts receivable and current liabilities or short-term debts and accounts payable of a firm. The said ratio is expressed as –

Current ratio = \[\frac{\text{Current assets}}{\text{Current liabilities}}\] 

2. Acid Test Ratio/Quick Ratio or Liquid Ratio

This ratio expresses a relationship between the quick assets and current liabilities of a firm. It is expressed as –

Liquid ratio = \[\frac{\text{Quick assets}}{\text{Current liabilities}}\]

Quick Assets = Marketable Securities + Accounts Receivable + Cash And Cash Equivalents

Quick Assets = Marketable Securities + Accounts Receivable + Cash And Cash Equivalents

Test Your Knowledge: With the help of the table below, segregate the items as current assets and current liabilities.

2. Solvency Ratio

The said ratio helps to determine the solvency or the ability of a business to pay its stakeholders for the long-term contractual obligation. Solvency ratio is of 4 types –

1. Debt-Equity Ratio

It is one of the most potent ratios in accounting, as it shows the relation between a firm’s long-term debts and its share of the equity. The ratio is expressed as – 

Debt-equity ratio= \[\frac{\text{Long-term debts}}{\text{Shareholders' funds}}\]

Do It Yourself: Show a breakdown of all the components of shareholders’ fund before you proceed to the new accounting ratio. 

2. Total Asset to Total Debt Ratio

It helps one to measure a firm’s efficiency in covering its share of long-term debts. It is expressed as – 

Total assets to total debt ratio = \[\frac{\text{Total assets}}{\text{Long-term debt}}\]

3. Interest Coverage Ratio

This accounting ratio helps to measure a relationship between the bulk of profits that is available to a firm for interest payment and the value of long-term debts. It is expressed as – 

Interest coverage ratio = Net profit \[\frac{\text{(before interest payment)}}{\text{Long-term debts}}\]

4. Proprietary Ratio

It signifies the relationship between shareholder’s funds to the capital employed or total assets. Typically, it is expressed as –

Proprietary ratio = Proprietors’ fund \[\frac{\text{(shareholders’ funds)}}{\text{capital employed or total assets}}\]

3. Profitability Ratio

The particular set of ratios helps to measure the profit and efficiency of a firm. There are five types of profitability ratio. Check them out below –

1. Operating Ratio

Operating Ratio = \[\frac{\text{(Cost of earnings generated through operations + Operating cost)}}{\text{Net earnings from operations × 100}}\]

2. Operating Profit Ratio

Operating Profit Ratio = \[\frac{\text{(Revenue from operation – Cost of operation)}}{\text{Revenue from operation × 100}}\]

3. Gross Profit Ratio

Gross Profit Ratio = \[\frac{\text{Gross Profit}}{\text{Net earnings from operations × 100}}\]

4. Net Profit Ratio 

Net Profit Ratio = \[\frac{\text{Net profit}}{\text{Revenue from Operations × 100}}\]

5. Return on Investment or Capital Employed

Return on Investment or Capital employed = \[\frac{\text{Gains before tax and interest}}{\text{Capital employed × 100}}\]

4. Turnover Ratio / Efficiency Ratio

This ratio in accounting tends to signify the frequency at which a firm performs its operation by employing its assets. Notably, a higher turnover ratio indicates effective utilization of assets and in turn, hints at proficiency. 

It is Further Divided into Four Types – 

1. Inventory Ratio 

Inventory turnover ratio = \[\frac{\text{Cost of revenue}}{\text{Average inventory}}\]

2. Trade Payable Turnover Ratio

Trade payable turnover ratio = \[\frac{\text{Net credit purchases}}{\text{Average trade payables}}\]

3. Trade Receivable Turnover Ratio

Trade receivable turnover ratio= \[\frac{\text{Net credit revenue}}{\text{Average trade receivable}}\]

4. Working Capital Ratio

Working capital turnover ratio = \[\frac{\text{Net earnings through operation}}{\text{Working capital}}\]

Learn about these accounting ratios and accounting ratio analysis in detail by joining Vedantu’s live online classes. Also, by accessing our PDF solutions, you would learn how to solve numerical using ratios in accounting to determine the financial standing and efficiency of a firm. 

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