Corporate Financial Accounting (CFA) class today was not only informative but also very interesting. For the first time, I got to really understand the story and underline meaning behind the numbers in a company’s Financial Statement. Unlike the past, it was not just figures and abstract analysis for me. Our Facilitator skillfully guided the class to understand, think and own their decision, when giving reasons why a certain decision may have been taken by the Management of the organisation. He informed us that, the ability to understand the financial health of a company, is one of the most vital skills for aspiring investors, entrepreneurs, and managers to develop. Armed with this knowledge, investors can better identify promising opportunities while avoiding undue risk, and professionals of all levels can make more strategic business decisions.
He told us that Financial statements, offer a window into the health of a company, which can be difficult to gauge using other means. While accountants and finance specialists are trained to read and understand these documents, many business professionals are not. But the “Reporting and Analysing Owner and Non-Owner Financing 2” class equipped the class with this knowledge.
What are Accounting Ratios?
Accounting ratios cover a wide array of ratios that are used by accountants and act as different indicators that measure profitability, liquidity, and potential financial distress in a company’s financials. The ratios are used by accountants and financial professionals to communicate and investigate problems or successes within a designated time period.
UNDERSTANDING FINANCIAL STATEMENTS WITH ACCOUNTING RATIOS
To understand a company’s financial position, investors and financial analysts can use Accounting ratios. Accounting ratios cover a wide array of ratios that are used by accountants and act as different indicators that measure profitability, liquidity, and potential financial distress in a company’s financials. The ratios are used by accountants and financial professionals to communicate and investigate problems or successes within a designated time period. Below are some commonly used Accounting Ratios;
Liquidity Ratios
This is used to ascertain a company’s liquidity position. It is used to determine its paying capacity towards its short- term liabilities. A high liquidity ratio indicates that the company’s cash position is good. A liquidity ratio of 2 or more is acceptable. Some examples of Liquidity ratios and their formulas are;
Current Ratio
The Current Ratio compares the current assets to the current liabilities of the business. This ratio indicates whether the company can settle its short-term liabilities.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio
The Quick Ratio is the same as the current ratio, except it considers only quick assets that are easy to liquidate. It is also called an acid test ratio.
Quick Ratio= Quick Assets/ Current Liabilities
Cash Ratio
The Cash Ratio considers only those current assets immediately available for liquidity. Therefore, the cash ratio is ideal if it is one or more.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
2 Profitability Ratios
This type of accounting ratio formula indicates the company’s efficiency in generating profits. It shows the earning capacity of the business in correspondence to capital employed.
Gross profit Ratio
The gross profit ratio compares the gross profit to the company’s net sales. It indicates the margin earned by the business before its operational expenses. It is represented as a percentage of sales. The higher the gross profit ratio, the more profitable the company is.
Gross Profit Ratio = (Gross Profits/ Net revenue from Operations) X 100
Operating Ratio
The operating ratio expresses the relationship between operating costs and net sales. It is used to check on the efficiency of the business and its profitability.
Operating Ratio= ((Cost of Goods Sold + Operating Expenses)/ Net Revenue from Operations) X 100
Operating expenses include administrative expenses, selling, and distribution expenses, salary costs, etc.
Net profit Ratio
The net profit ratio shows the overall profitability available for the owners as it considers both the operating and non-operating income and expenses. Higher the ratio, the more returns for the owners. It is an important ratio for investors and financiers.
Net Profit Ratio = (Net Profits After Tax / Net Revenue) X 100
3 Leverage Ratios
These types of accounting ratios are known as solvency ratios. That is because it determines its ability to pay for its debts. Investors are interested in this ratio as it helps to know how solvent the company is to meet its dues.
Debt to Equity ratio
It shows the relationship between total debts and the company’s total equity. It is useful to measure the leverage of the company. A low ratio indicates that the company is financially secure; a high ratio suggests that it is at risk as it is more dependent on debts for its operations. It is also known as the gearing ratio. The ratio should be a maximum of 2:1.
Debt to Equity Ratio = Total Debts / Total Equity
Debt ratio
The Debt Ratio measures the liabilities in comparison to the assets of the company. A high ratio indicates that the company may face solvency issues.
Debt Ratio = Total Liabilities/ Total Assets
Proprietary ratio
It shows the relationship between total assets and shareholders’ funds. It indicates how much of shareholders’ funds are invested in the assets.
Proprietary Ratio = Shareholders Funds / Total Assets
Interest Coverage ratio
The Interest Coverage Ratio measures its ability to meet its interest payment obligation. A higher ratio indicates that the company earns enough to cover its interest expense.
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense
4 Activity/Efficiency Ratios
Working Capital Turnover Ratio
It establishes the relationship of sales to Net Working Capital. A higher ratio indicates that the company’s funds are efficiently used.
Working Capital Turnover Ratio = Net Sales/ Net Working Capital
Inventory Turnover Ratio
The Inventory Turnover Ratio indicates the pace at which the stock is converted into sales. Therefore, it is useful for inventory reordering and understanding the conversion cycle.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Asset Turnover Ratio
The Asset Turnover Ratio indicates the revenue as a percentage of the investment. A high ratio suggests that its assets are managed better, yielding good income.
Asset Turnover Ratio = Net Revenue / Assets
Debtors turnover ratio
The debtors’ turnover ratio indicates how efficiently debtors’ credit sales value is collected. In addition, it shows the relationship between credit sales and the corresponding receivables.
Debtors Turnover Ratio = Credit Sales/Average Debtors
Conclusion
Accounting ratios are useful in analysing a company’s performance and financial position. They acts as benchmarks used by companies to compare their performance which each other. In addition, they allows investors to carry out stock valuation and are also used for macro-level analysis, for in-depth research needs to understand a business properly.
Reference
Peter D. Easton, John J. Wild, Robert F. Halsey, Mary Lea McAnally. (2015). Financial Accounting for MBAs. In: Cambridge Business Publishers Financial Accounting for MBAs. 6th ed. United States of America: Cambridge Business Publishers. p9 – 10.
Anugraha G. (2022). Accounting Ratios. Available: https://www.wallstreetmojo.com/accounting-ratios/. Last accessed 25th March 2022.
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