Accounting Ratios

What are Accounting Ratios?

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 in the future. The ratios may seem simple at first, but they are incredibly nuanced and can be challenging to calculate when attempting to analyze and quantify Fortune 500 companies.

Below, we provide a high-level overview of why accounting ratios are important, along with some examples that we may encounter in our everyday professional and personal lives.

Common Accounting Ratios

There are many accounting ratios used throughout the industry, categorized into subcategories such as 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

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.

Key Takeaway

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.

Additional Resources

Thank you for reading CFI’s guide to Accounting Ratios. To keep advancing your career, the additional resources below will be useful:

• Credit Analysis Ratios
• Efficiency Ratios
• Leverage Ratios
• Ratio Analysis
• See all accounting resources