Indicators that measure profitability, liquidity, and potential financial distress in a company’s financials
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Accounting ratios cover a wide array of ratios that are used by accountants and act as different indicators that measure profitability, liquidity, and potential financial distress in a company’s financials. The ratios are used by accountants and financial professionals to communicate and investigate problems or successes within a designated time period.
Often, accounting ratios are calculated yearly or quarterly, and different ratios are more important to different industries. For example, the inventory turnover ratio would be significantly important to a retailer but with almost no significance to a boutique advisory firm.
The financial reports that accounting ratios are based on represent much of the core essence of a business. They paint a picture of where a company came from, how they are doing currently, and where they are going into the future. The ratios may seem simple at first, but they are incredibly nuanced and can be difficult to calculate once one is attempting to analyze and quantify Fortune 500 companies.
Below, we present a high-level overview of why accounting ratios are important and some examples of accounting ratios that we may come across in our everyday professional and personal lives.
Common Accounting Ratios
There exist many accounting ratios used throughout the industry, divided into subcategories like profitability ratios, debt ratios, and liquidity ratios, among others. We will highlight some of the more common ratios in the table below that you may use as a handy reference:
Commonly Used Debt Ratios and Formulas
1. Debt-to-Equity Ratio = Liabilities (Total) / Shareholder Equity (Total)
2. Debt Ratio = Total Liabilities/Total Assets
Commonly Used Liquidity Ratios and Formulas
1. Current Ratio = Current Assets/Current Liabilities
2. Quick Ratio = [Current Assets – Inventory – Prepaid Expenses] / Current Liabilities
Commonly Used Profitability Ratios and Formulas
1. Return on Equity = Net Income / Average Shareholder Equity
2. Gross Margin = Gross Profit / Net Sales
3. Return on Assets = Net Income/Total Assets
Non-Accountants and Accounting Ratios
Accounting ratios come with wide-reaching use and necessity, even for those of us who are not accountants. Many of us like to invest money that we look at as long- or short-term opportunities. A savvy investor knows how to use accounting ratios to determine whether a stock presents a lucrative opportunity or perhaps a liability that other investors have yet to realize.
For example, if you were analyzing a company’s financials to calculate the debt ratios and determined that the company took on too much short- and long-term debt to remain profitable, you may choose not to invest or may decide to short the stock instead. Accounting ratios help you to decide on a particular position, investment period, or whether to avoid an investment altogether.
Accounting ratios are useful if you are looking to start your own business as well. Understanding your finances can help you budget, understand, and identify areas for improvement, as well as learn how to properly take on debt in order to help your business grow.
As a manager, you may also need to understand the accounting ratios being explained to you by your accountants. They can better help you make decisions and understand the overall health and profitability of your division.
Accounting Ratios: Taken in Context
Accounting ratios are an excellent tool to help us determine the financial health of a company. However, they do not show the whole picture, and we must always be careful to take them into context. For example, Amazon is a company that values growth over profitability. Thus, if one were to analyze Amazon’s profitability ratios historically, it might have misleadingly indicated that the company was under financial stress at times when, in fact, it was the total opposite.
Amazon always chooses to reinvest its income into growth instead of taking it as profit. The online giant retailer, in this instance, is practicing a strategic macro decision that may affect the micro ratio indicators. Applying accounting ratios to companies requires background knowledge to ensure they are properly interpreted.
Understanding accounting ratios and how to calculate them can make you an effective finance professional, small business owner, or savvy investor. The ratios can help provide insights into financial areas that others may be missing or that you can plan to avoid in your own business.
Thank you for reading CFI’s guide to Accounting Ratios. To keep advancing your career, the additional resources below will be useful:
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