Accounting Ratios Overview, Examples, Formulas

It is to be noted that the first approach to the computation of the debtors turnover is superior. In case of the second approach the effect is that debtors turnover ratio is inflated. A high inventory ratio indicates efficient inventory management and efficiency of business operations. The term fictitious assets refer to preliminary expenses, debit balance of Profit and Loss Account and other similar losses shown on Balance Sheet asset side. The profit considered for computing the ratio is taken after payment of preference dividend. The net profit here is net income after payment of interest and tax and it includes net non- operating income also, (i.e., Non-operating income minus non- operating expenses).

• You are required to show the activity ratios of X Ltd. and comment on them.
• The ratios comprising this category are calculated with reference to sales or cost of sales and expressed in number of times, i.e., rate of turning over or rotation.
• The higher the dividend payout ratio the higher percentage of income a company pays out as dividends as opposed to reinvesting back into the company.
• The accounting ratios are affected by personal bias, skills of the analyst, and price level changes.
• The purpose of the debt-equity ratio is to see if a business is properly balancing the amount of funding raised from stock sales to the amount of funding raised from debt.

The objective of calculating this ratio is to ascertain the proportion of long-term funds invested in fixed assets. It is a ratio which relates the total tangible assets with the total borrowed funds. In a sense, it is the ‘other side of the coin’ for proprietary ratio. Higher sales in comparison to working capital indicate overtrading and a lower sale in comparison to working capital indicates under trading.

Market Prospect Ratios

Acid Text Ratio establishes a relationship between quick or liquid assets and current liabilities. Liquid assets refer to those assets, which can be converted into cash quickly and easily without a loss in value. In that sense, cash and bank balances are more liquid than the other assets. Current Assets include cash, bank, and other assets that can be converted into cash within a year, such a marketable securities, debtors and inventories.

The higher the figure, the more likely a company is to be able to meet its interest payments. Inventory holding period

This is calculated in a very similar way to the receivables collection period. Again, for liquidity purposes the shorter this period the better, as less cash is tied up in inventory. Also, long inventory holding periods can result in obsolete inventory.

Accounting Ratios: Uses and Types (With Calculations)

For example, if your company’s financial obligations are $50,000 and its assets are $100,000, your debt ratio is 0.5. That’s not bad, because it indicates that your company owes less than it owns. A debt ratio higher than 1, however, shows that your company has more liabilities than assets. For example, if your company’s liabilities total $100,000 and its equity is $50,000, the debt-to-equity ratio would be 2. On the other hand, if the debt were $50,000, the debt-to-equity ratio would be 1, putting you in a safer position.

Analysts can use activity ratios to assess a company’s inventory management, which is critical to its operational flexibility and overall financial health. An activity ratio is a financial indicator that investors and research analysts use to determine how well a firm uses its assets to create revenue and cash. Activity ratio determines the efficiency by which a company is utilizing its assets to generate revenue and cash or bank balance.

Overview: What are accounting ratios?

This ratio compares the total amount of all types of debt to the total amount of equity appearing on the balance sheet. The purpose of the debt-equity ratio is to see if a business is properly balancing the amount of funding raised from stock sales to the amount of funding raised from debt. A high ratio may not be supportable if a company’s cash flows are not consistent enough to make periodic interest and principal payments on its debt. The ratio of current assets to current liabilities is called ‘current ratio’. In order to measure the short-term liquidity or solvency of a concern, comparison of current assets and current liabilities is inevitable. Current ratio indicates the ability of a concern to meet its current obligations as and when they are due for payment.

It compares all current assets except inventory to current liabilities. Inventory is excluded from the comparison, because it can be difficult to convert to cash. The purpose of the quick ratio is to see if a business has enough assets that can be reasonably converted into cash to meet its current obligations. Because we’re only concerned with the most liquid assets, the ratio excludes inventories from current assets. Analyzing fsa vs hsa is an important step in determining the financial health of a company.

What Is an Accounting Ratio?

A company’s accounting ratios can be compared to the ratios of other companies in the same industry. An accounting ratio can also be compared to the company’s same ratio in recent periods to see whether the company is improving or declining. A business with $125,000 in liabilities and $180,000 in shareholder’s equity would have a debt-to-equity ratio of 0.69. The only difference in the calculation is the inclusion of any inventory totals.

The term financial position generally refers to short-term and long-term solvency of the business concern, indicating safety of different interested parties. The significant financial ratios are classified as short-term solvency ratios and long-term solvency ratios. Debtors turnover ratio measures the number of times the receivables are rotated in a year in terms of sales. This ratio also indicates the efficiency of credit collection and efficiency of credit policy. The ratio is helpful in determining the operational efficiency of a business concern and the effectiveness of its credit policy. It is important to maintain a reasonable quantitative relationship between receivables and sales.

But, it fails to reflect how much is paid as dividend and how much is retained in the business. The operating expense ratio is used for measuring the operating efficiency. It is advisable to use this ratio very cautiously since it is affected by a number of factors, such as external uncontrollable factors, internal factors. You are required to show the activity ratios of X Ltd. and comment on them.

Solvency Ratios – second among types of accounting ratios is solvency ratios; it helps to determine a company’s long-term solvency. It is often used to judge the long-term debt paying capacity of a business. Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements.

Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company’s financial standing with industry averages while measuring how a company stacks up against others within the same sector. Working capital ratio measures the effective utilisation of working capital. The ratio establishes relationship between cost of sales and working capital.

There is no doubt that ratios can be an invaluable aid to management and others who are interested in analysing the operations and the state of affairs of a business. Absolute figures may be misleading unless compared one with another, ratios provide the means of showing the interrelationships which exist. “Communication” is the process used to impart knowledge within the business or to outside shareholders or other interested parties. Accounting ratios can play vital role in informing what has happened from one period to another. Ideal ratios can be established and the relationships between primary ratios may be used to establish the desirable co-ordination or balance. The FMA/MA syllabus introduces candidates to performance measurement and requires candidates to be able to ‘Discuss and calculate measures of financial performance and non-financial measures’.

Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. All of these sorts of ratios are used to track business performance and compare results to those of competitors. Additionally, such ratios can be stated as a fraction, %, proportion, or number of times. The financial statements determine the correctness and efficiency of accounting ratios as a financial statement analysis tool. This is because the two or more accounting statistics used to calculate a financial ratio are obtained from such statements.

The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. Instead, ratio analysis must often be applied to a comparable to determine whether or a company’s financial health is strong, weak, improving, or deteriorating. This ratio measures the amount of debt taken by a business as against the equity. Accounting ratios are one of the important tools of financial statement analysis.