Accounting ratios tell the
story of financial health
Accounting ratios are used to analyze your personal or business financial health. It evaluates the three financial statements (Balance Sheet, Profit & Loss (Income) Statement, and Cash Flow Statement).
There are four groups of accounting ratios.
- Liquidity Ratios – answer the question, “Can a unit pay its bills?”
- Asset Management Ratios – answer, “Are our assets being used efficiently?”
- Profitability Ratios – answer, “How good is management at making a profit?”
- Leverage Ratios – answer, “Do we have too much debt?”
From the Balance Sheet
and Income Statement several ratios are calculated.
There are two accounting ratios that measure a unit’s liquidity. These equations use the values reported in the Balance Sheet.
The first ratio is called Current Ratio. This ratio answers the question, “Can the current assets pay the current liabilities. “Yes” is the answer if the current ratio is greater than or equal to 1.0. A value of 2.0 should be the target. This provides some cushion.Current Ratio = Current Assets / Current Liabilities
Equation 1: Current Ratio
Another liquidity ratio used is called the Quick Ratio. It is a conservative ratio reporting if there is enough cash and receivables to pay the bills due in 12 months.Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
Equation 2: Quick Ratio
Asset Management Ratios
There are three accounting ratios that measure a unit’s ability to effectively use their assets to produce income. These equations use the values reported in the Income Statement and Balance Sheet.
The first ratio is Asset Turn Ratio. A measure of how well a unit is using its assets to make sales.Asset Turn = Net Sales / Total Assets
Equation 3: Asset Turn Ratio
At times one may want to know how long does it take on average to get paid for a product sold? The ratio used to answer that question is called Receivable Days.Receivable Days = 365(Accounts Receivable) / Net Sales
Equation 4: Receivable Days
The last ratio measures how fast one is using the inventory. Inventory Turn = Cost of Goods / Inventory
Equation 5: Inventory Turn
How well is management doing at making profits for its owners. There are four accounting ratios that answer this question. The ratios use the values reported in the Income Statement and Balance Sheet.
The first ratio measures how well management is doing at using the assets to make a profit. This measurement is called Return on Assets (ROA).ROA = Net Income / Total Assets
Equation 6: Return on Assets
Now lets look at another ratio to determine how well management is using money invested by shareholders. This is ratio is called Return on Equity (ROE) or Return on Investment (ROI).ROI = Net Income / Shareholder's Equity
Equation 7: Return on Equity or Return on Investment
Next lets determine the profit margin of a company. Also called Return on Sales (ROS).ROS = Net Income / Net Sales
Equation 8: Return on Sales "Profit Margin"
The last profitability ratio is Gross Margin, the percentage of profit over the cost of goods. Gross Margin = (Net Sales - Cost of Goods) / Net Sales
Equation 9: Gross Margin "Gross Profit"
Does a unit operate with too much debt? There are two accounting ratios that answer this question. From the Balance sheet these ratios are calculated.
Does a unity have more debt than equity? Will a company be able to repay a loan out of their equity? This is answered with the Debt-to-Equity Ratio (DTE). DTE = (Current Debt + Long-Term Debt) / Shareholder's Equity
Equation 10: Debt-To-Equity Ratio
The second ratio compares debt to assets. Debt Ratio = (Current Debt + Long-Term Debt) / Total Assets
Equation 11: Debt Ratio
In summary, you now know the 11 basic accounting ratios that compares a unit’s performance. Measuring how well they produce more with less. Liquidity and leverage ratios report the future survival of a company. Investors determine future success with profitability ratios. With this knowledge you can now determine the financial health of a person or business.
Return from Accounting Ratios to 12 Accounting Principals