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 ratios, but we will check them out once we become familiar with the fundamental aspects of accounting ratio in general.
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
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 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 analysing 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 ratio in brief.
There are four types of ratios in accounting. Find more about them below –
This particular accounting ratio helps to measure a firm’s liquidity or their ability to repay its short-term financial liabilities at any given point of time. Liquidity ratio is further divided into two types, namely –
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 = Current assets / Current liabilities
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 = Quick assets / Current liabilities [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.
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 –
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= Long-term debts / Shareholders' funds
Do It Yourself: Show a breakdown of all the components of shareholders’ fund before you proceed to the new accounting ratio.
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 = Total assets / Long-term debt
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 (before interest payment) / Long-term debts
It signifies the relationship between shareholder’s funds to the capital employed or total assets. Typically, it is expressed as –
Proprietary ratio= Proprietors’ fund (shareholders’ funds) / capital employed or total assets
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 –
Operating Ratio = (Cost of earnings generated through operations + Operating cost)/ Net earnings from operations × 100
Operating Profit Ratio
Operating Profit Ratio = (Revenue from operation – Cost of operation) / Revenue from operation × 100
Gross Profit Ratio
Gross Profit Ratio = Gross Profit / Net earnings from operations × 100
Net Profit Ratio
Net Profit Ratio = Net profit / Revenue from Operations × 100
Return on Investment or Capital Employed
Return on Investment or Capital employed = Gains before tax and interest / Capital employed × 100
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 utilisation of assets and in turn, hints at proficiency.
It is Further Divided into Four Types –
Inventory turnover ratio = Cost of revenue / Average inventory
Trade Payable Turnover Ratio
Trade payable turnover ratio = Net credit purchases / Average trade payables
Trade Receivable Turnover Ratio
Trade receivable turnover ratio= Net credit revenue / Average trade receivable
Working Capital Ratio
Working capital turnover ratio = Net earnings through operation / 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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1. What is the Accounting Ratio?
Ans. Accounting ratios can be defined as a mathematical expression that factors in financial data to show a firm’s financial standing, performance, and ability to pay debts.
2. What are the Different Accounting Ratios?
Ans. In the broad sense, accounting ratios can be divided into four types – liquidity ratio, solvency ratio, turnover ratio, and proficiency ratio.
3. Why are Accounting Ratios Useful?
Ans. Accounting ratios are deemed helpful as they help both business owners and potential investors to ascertain a firm’s financial standing and formulate strategies accordingly.