Accounting ratios, also known as financial ratios, are comparisons made between one set of figures from a company’s financial statement with another in order to determine whether it can pay its debts, how profitable it is, or whether it is likely to go bankrupt soon. The general aim when examining these ratios is to analyze trends.
Accounting ratios are indicators of a commercial entity’s performance and financial situation. The majority of ratios can be calculated from data provided by the firm’s own financial statements.
Financial ratio sources could be the balance sheet, income statement, statement of cash flows, or the statement of changes in equity – from within the company’s financial statements or accounting statements.
There are many different types of accounting ratios. They tell us how healthy/unhealthy a company is, its ability to meet its financial obligations, how profitable it is, and the likelihood of it thriving or going bankrupt in the near future.
“Financial ratios are useful indicators of a firm’s performance and financial situation. Most ratios can be calculated from information provided by the financial statements.”
“Financial ratios can be used to analyze trends and to compare the firm’s financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy.”
Most common accounting ratios
There are many types of accounting ratios, depending on the information they contain. The following are the most frequently used ratios:
– Absolute Liquid Ratio: the relationship between absolute liquid or super quick current assets and liabilities.
‘Financial ratios’ has the same meaning as ‘accounting ratios’. They are comparison calculations we make to see how well a commercial enterprise is faring.
– Activity Ratios: measure a company’s ability to convert different accounts within its balance sheets into cash or sale.
– Asset Turnover Ratios: measure the efficiency of a commercial entity’s use of its assets in generating sales revenue to the business.
– Current Cash Debt Coverage Ratio: measures the relationship between net cash that operating activities provide and the average current liabilities of the firm.
– Current Ratio or Working Capital Ratio: measures a business’ ability to pay short- and long-term obligations.
– Debt Service Coverage Ratio: also known as DSCR, is the ratio of liquid cash available for debt servicing to interest, principal and lease payments. It measures a firm’s ability to service its current debts by comparing its net operating income to its total debt service obligation.
– Dividend Policy Ratios: the most common are Dividend Payout Ratio, Dividend Yield and Dividend Cover. The Dividend Payout Ratio tells us how well earnings support dividend payouts.
– Financial Leverage Ratios: measure the overall debt load of a commercial enterprise and compare it with the assets or equity.
– Liquidity Ratios: tell us how well a company can pay off both its current liabilities as they become due, plus their long-term liabilities as they become current. They tell us what the cash levels of a firm are, and its ability to turn assets into cash to pay off liabilities and current obligations.
– Profitability Ratios: measures that tell us how well a company is performing in terms of its ability to generate profit.
– Quick Ratio or Acid Test Ratio: measures a firm’s liquidity and ability to meet its financial obligations. It is viewed as a sign of a business’ financial strength or weakness.
Ratios can be expressed as numbers or percentage values. Some ratios such as earnings yield, are quoted as percentages – the ones that are always less than 1.
Ratios that are usually more than 1 are quoted in decimal numbers (1.0, 1.1, 1.2, etc.), such as P/E ratio – these are called multiples.
You can take any ratio’s reciprocal – if that ratio is above 1, the reciprocal will be below 1, and vice versa. In some cases, the reciprocal may be easier to understand.
Why are accounting ratios used?
Accounting ratios are used to make comparisons:
– between different accounting periods of the same company
– between one company adn the average within its industry
– between different companies
– between industries
A ratio is only useful if it is benchmarked against something else, like another company or past performance.
Video – Top 10 Accountancy Ratios
This video looks at the top 10 most common financial ratios that appear in accountancy exams.