ACCOUNTING RATIO

Accounting Ratios

Accounting ratios, also called financial ratios, are used in analyzing financial statements. A ratio shows the relationship between two amounts. However, a ratio by itself may have no meaning until it is compared to ratios from previous years (called time series analysis) or ratios of other firms in the same industry (called cross-sectional analysis).

Advantages and Limitations of Using Accounting Ratios

The use of accounting ratios is useful because it provides a quick summary of financial statements. This helps with trend analysis of a company, and also provides a way to compare companies of different sizes.
The limitations of ratio analysis include the inability for comparisons to be made across industries due to the fact that acceptable ratios vary by industry. Even within an industry, comparisons may not be accurate because different companies may make different assumptions in preparing financial statements. Plus, ratio analysis focuses on the past, rather than the present or future.

Types of Accounting Ratios

A number of possible ratios can be used to analyze financial statements, including the following most commonly used accounting ratios:

Liquidity ratios show how liquid the organization is. An organization is liquid if it can pay its bills on time. Four liquidity ratios are:

• Current Ratio is one of the most commonly used ratios. It is equal to Current Assets divided by Current Liabilities.
• Quick Ratio = Quick Assets / Current Liabilities
• Quick Assets = Cash + Short Term Securities + Accounts Receivable
• Net Working Capital Ratio = (Current Assets - Current Liabilities) / Total Assets

Profitability ratios show an organization's returns on investments. Profitability ratios include:

• Profit Margin = Net Income / Revenue
• Return on Assets = Net Income / Average Total Assets
• Average Total Assets equals ending plus beginning Total Assets divided by two
• Return on Equity = Net Income / Average Stockholders' Equity
• Average Stockholders' Equity equals beginning plus ending stockholders' equity divided by two. Return on Common Equity is a similar ratio but uses average common stockholders' equity.

Capital structure ratios show how an organization has financed the purchase of assets and include:

• Debt to Equity Ratio = Total Liabilities / Total Stockholders' Equity
• Interest Coverage Ratio = Income Before Income Taxes and Interest Expense)
• Debt to Asset Ratio = Total Liabilities / Total Assets

Market value ratios show the value created for shareholders and include:

• Price Earnings (P/E) ratio = Price per share of common stock / Earnings per share
• Dividend yield = Per share dividend / Per share price
• Dividend payout ratio = Common Stock Cash Dividends / Net Income
• Market to Book Ratio = Common share market value / Common share book value

Activity analysis ratios show how efficient the organization has been in using its assets to generate sales and include:

• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
• Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
• Assets Turnover Ratio = Sales / Average Total Assets