What Is an Accounting Ratio?
Accounting ratios, an important subset of financial ratios, are a group of metrics used to measure themanagement aptitude, efficiency, andprofitabilityof a company based on its financial reports.They provide a way of expressing the relationship between one accounting data point to another and are the basis ofratio analysis. They also serve as a comparison toolbox to compare the firms' performance to that of its peer in the same industry.
Key Takeaways
- Accounting ratios are a group of metrics used to measure the efficiency and profitability of a company based on its financial reports.
- An accounting ratio compares two line items in a company’s financial statements that are made up of its income statement, balance sheet, and cash flow statement.
- These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.
- Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.
- Accounting ratios are used by the company to make improvements or monitor progress as well as by investors to determine their best investment options.
Understanding an Accounting Ratio
An accounting ratio compares two line items in a company’s financial statements. These consist of its income statement, balance sheet, and cash flow statement. The ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.
Analyzing accounting ratios is an important step in determining the financial health of a company. It can often point out areas that are dragging the profitability of a company down and therefore need improvement. The effectiveness of new management plans, new products, and changes in operational procedures can all be determined by analyzing accounting ratios.
Accounting ratios also work as an important tool in company comparison within an industry. The company can see how it stacks up against its peers and investors can use accounting ratios to determine which company is their better option.
A thorough accounting analysis can be a complex task but calculating accounting ratios is a simple process of dividing two line items found on a financial statement that provide a quick form of clear analysis to a business owner or investor.
Types of Accounting Ratios
Several types of accounting ratios can determine various types of information.
Gross Margin and Operating Margin
The income statement contains information about company sales, expenses, and net income. It also provides an overview of earnings and the number of shares outstanding used to calculate earnings per share (EPS). These are some of the most popular data points that analysts use to assess a company’s profitability.
Gross profit as a percent of sales is referred to as gross margin. It's calculated by dividing gross profit by sales. The gross profit margin would be 80% if gross profit is $80,000 and sales are $100,000. The higher the gross profit margin, the better. It indicates that a company is keeping a higher proportion of revenues as profit rather than using it to meet expenses.
Operating profit as a percentage of sales is referred to as operating margin. It's calculated by dividing operating profit by sales. The operating profit margin would be 60% if the operating profit is $60,000 and sales are $100,000.
Debt-To-Equity Ratio
The balance sheet provides accountants with a snapshot of a company’s capital structure. One of the most important measures of capital structure is the debt-to-equity (D/E) ratio.
It's calculated by dividing debt by equity. The debt-to-equity ratio would be two to one if a company has debt equal to $100,000 and equity equal to $50,000. The debt-to-equity ratio shows how much a business is leveraged: how much debt it's using to finance operations rather than its internal funds.
The Quick Ratio
The quick ratio is also known as the acid-test ratio. It's an indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets. The ratio excludes inventories from current assets because we're only concerned with the most liquid assets in this case.
Dividend Payout Ratio
The cash flow statement provides data for ratios dealing with cash. The dividend payout ratio is the percentage of net income paid out to investors through dividends. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement.
The dividend payout ratio is calculated by dividing $100,000 by $400,000, which works out to 25%, if dividends are $100,000 and income is $400,000. The higher the dividend payout ratio, the higher the percentage of income a company pays out as dividends rather than reinvesting back into the company.
What Are Shares Outstanding?
Shares outstanding are those that are available to investors. They include shares held by company employees and institutional investors. The number can fluctuate when employees exercise stock options or if the company issues more shares.
What Are Some Examples of Liquid Assets?
Liquid assets include cash and anything that can be easily converted to cash. They include marketable securities, government bonds, foreign currencies, and treasury bills. Cash can be on hand or held in various bank accounts and savings vehicles.
How Can an Investor Use Accounting Ratios?
Accounting ratios provide a view of a company's financial health but they're only one viable tool when you're assessing investments. They can measure a company's liquidity and profitability but this information should be taken in light of other factors to get a complete picture of its sustainability and potential earnings.
The Bottom Line
Accounting ratios can provide an accurate assessment of the profitability of a company over the last quarter or fiscal year. They include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.
These are just a few examples of the many accounting tools that corporations and analysts use to evaluate a company, however. Many other tools highlight different aspects of a company so you’ll want to explore and potentially use them as well.
