Financial analysts use various ratios to analyze a company’s financial position. Accounting ratios cover a wide array of ratios used by accountants and act as indicators that measure profitability, liquidity, and potential financial distress in a company’s financials. Accountants and financial professionals use the ratios to communicate and investigate problems or successes within a designated period. Ratio analysis involves studying multiple relationships between different items reported in financial statements.
We have different ratio categories; however, we will discuss two major ratios, Profitability and Liquidity, in today’s blog post.
PROFITABILITY
Profitability is the capacity to make a profit. This ratio is used to measure the profitability of a business and to know the organization’s financial position or the business’s gain within a particular period. These ratios are considered favorable when they improve over a trend line or are comparatively better than competitors’ results.
The major types of profitability ratios are as follows:
1. Gross profit ratio – This is used to determine the proportion of sales still available after goods and services have been sold to pay for selling and administrative costs and generate a profit. Gross margin tells you about the profitability of your goods and services. It tells you how much it costs you to produce the product.: When the gross profit ratio of a company is high, we can say the organization is in a good financial position. Its formula is expressed as:
= Gross profit / Net sales x 100
2. Net profit ratio – This is the amount remaining from sales after the cost of goods has been deducted. Net profit is the real profit of any organization. If this ratio is high, then the organization is going toward profit. Its formula is expressed as:
= Net profit / Net sales x 100
3. Asset turnover – This ratio is also called the turnover of asset ratio. It measures how many sales were generated for each amount of assets invested. Its formula is expressed as:
= Net sales / Average total asset
4. Return on investment – This is also called return on assets or earning power, or return on capital investment. It is the ratio of wealth generated to the amount invested in creating wealth. ROI tries to directly measure the amount of return on a particular asset relative to the investment’s cost. Its formula is expressed as:
= Net income/ Average total asset
5. Return on equity – It measures the profitability of the stockholder’s investment, or we can say that it is a gauge of a corporation’s profitability and efficiency in generating profits. ROE is higher than ROI because of the financial leverage. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity. Its formula is expressed as:
= Net income / Average total stockholders’ equity
LIQUIDITY
Liquidity is a crucial aspect to consider. The Liquidity ratio is used to determine the current debt-repaying ability of a borrower, or we can say that it shows a company’s ability to pay its short-term debts. It focuses on current assets and current liabilities. Below are the liquidity ratios:
- Current ratio – This is also called the working capital ratio. Current ratios imply a company’s financial capacity to clear off its current obligations using its assets. The current assets include cash, receivables, prepaid expenditures, deposits, etc., and current liabilities include short-term loans, creditors, and other payables. Its formula is expressed as:
= Current asset / Current liabilities
- Account receivable ratio – The accounts receivable turnover ratio, also known as the debtor’s turnover ratio, is an efficiency ratio that measures how efficiently a company collects revenue and, by extension, how efficiently it uses its assets. The accounts receivable turnover ratio measures the times a company collects its average accounts receivable over a given period.
= Net credit sales / Average account receivable
- Inventory ratios – Inventory turnover means the no of times, on average, that inventory is replaced during the year. Its formula is expressed as:
=Cost of goods sold/ Average inventory
- Quick ratio – This ratio is also known as the acid test ratio. It is a conservative variation of the current ratio.Its formula is expressed as:
= Quick assets / Current liabilities
- Working capital – This measures the excess funds a business will have available for operations, excluding any new funds it will generate during the year.Its formula is expressed as:
= Current asset – Current liability
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Written by Tutty Tero
This post is an exposition to accounting basic ratio.