Have you heard of Accounting Ratios? If not, here is a brief explanation about them.
Accounting ratios are a useful tool for analyzing a company’s financial reports. They are a type of financial ratio that measures how efficient and profitable a company is.
- It shows the relationship between one accounting data point to another.
- It is the basis for calculating ratio analysis.
Types of Accounting Ratios
1. Liquidity Ratio
This Ratio tells us how quickly a company can turn its assets into cash to pay its debts. A higher liquidity ratio means the company can pay its debts more easily.
a. Current ratio
The Current Ratio is a way to see if a company can pay off its debts in the next 12 months.
b. Cash ratio
The Cash Ratio is another way to see if a company can pay off its debts, but it only looks at how much cash or easily-sold assets the company has. So, the Cash Ratio is a more conservative measure of a company’s ability to pay off its debts.
Simply we can say,
Current Ratio = Current Assets/ current Liabilities and,
Cash ratio = Cash and equivalent/ current liabilities
2. Asset Turnover Ratio
It measures the value of a company’s sales or revenues relative to the value of its assets.
It can be used as an indicator to see the efficiency of the company which is using its assets to generate revenue.
There are two types in Asset Turnover Ratios:
a. Receivables Turnover Ratio It measures,
- The ability to collect on its receivables or credit which is extended to
- How many times a company’s receivables are converted into cash in a certain period.
b. Inventory Turnover Ratio
- It displays how frequently a business turned over its inventory in relation to its cost of goods sold (COGS) during a specific time frame.
- The number of days in the period typically a fiscal year can then be divided by the inventory turnover ratio to determine the average number of days it takes for a company to sell its inventory.
In a simple manner,
Receivable Turnover ratio= Annual credit sales/Accounts receivables and,
Inventory Turnover Ratio= Cost of goods sold/ average Inventory
3. Financial Leverage Ratio
Leverage ratio is any of several financial metrics that examine the amount of capital that comes from debt (loans) or evaluates a company’s capacity to satisfy its financial obligations.
Companies employ a combination of stock and debt to finance their operations, therefore the leverage ratio category is crucial. By understanding how much debt a firm has, you can assess its ability to pay off its loans when they become due.
The categories are,
a. Debt Ratio refers to a financial ratio that assesses how much leverage a business has. The ratio of total debt to total assets, represented as a decimal or percentage.
b. Debt To Equity Ratio used to estimate the financial leverage of a company and is calculated by dividing the total debt of the company by the equity of its shareholders. This is an important metric for corporate financing.
The formula will be as follows,
Debt Ratio= Total debt/Total Assets.
Debt to Equity Ratio= Total Liabilities/shareholder’s Equity
4. Profitability Ratios helps in determining the financial performance of business at the end of an accounting Period. It showcases the efficiency of company’s capability in making profits from its operations.
Under this, there are 2 kinds:
a. Return on Assets (ROA)
A financial ratio that shows a company’s profitability in relation to its total assets is referred to as ROA. ROA can be used by corporate management, analysts, and investors to figure out how effectively a company uses its assets to make money.
b. Gross Profit Margin (GPM)
The amount of money left over from product sales after deducting the Cost of Goods Sold (COGS) is a metric that analysts use to evaluate a company’s financial health.
Return on Assets = Net Income/Total assets
And,
Gross Profit Margin= Sales- COGS/Sales
5. Dividend policy Ratios
The ratio of a company’s dividend payout to its earnings and share market value is known as a dividend policy ratio. These ratios shed light on a company’s dividend policy. They measure the proportion of a company’s earnings that are distributed as dividends by comparing the dividends to earnings.
a. Payout Ratio
It is financial metric showing the proportion of a earnings of a company pays its shareholders in the form of dividends and can be expressed as a percentage of total earnings of a company.
b. Dividend Yield
It helps to measure the annual value of dividends received relative to the market value per share of a security.
Payout Ratio = Dividend per share/ Earning per share
Dividend Yield = Dividend per share/share price
