Accounting Ratios include a wide array of ratios that are used by accountants and other financial professionals which act as different indicators that measure profitability, liquidity, and potential financial distress in a company’s financials.
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 have almost no significance to a boutique advisory firm.
The financial reports that accounting ratios are based on paint a picture of where a company came from, how they are doing currently, and where they are going into the future.
Let’s look at some common accounting ratios with definitions from Corporate Finance Institute.
3 common accounting ratios include debt ratios, liquidity ratios, and profitability ratios.
What Are Common Debt Ratios?
Common Debt Ratios (sometimes called “solvency ratios” ) – these measure a company’s long-term ability to pay off its debt obligations.
- Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity (Total). Describes to what extent a company is financed by debt relative to equity.
- Debt Ratio = Total Liabilities/Total Assets. Measures how much of a company’s assets are financed by debt; in other words, its financial leverage.
What Are Common Liquidity Ratios?
Common Liquidity Ratios – these measure a company’s ability to meet short-term obligations.
- Current Ratio = Current Assets/Current Liabilities. Measures the capability of a business to meet its short-term obligations that are due within a year.
- Quick Ratio = [Current Assets – Inventory – Prepaid Expenses] / Current Liabilities. Measures a company’s ability to pay its short-term debts with its most liquid assets.
What Are Profitability Ratios?
Common Profitability Ratios – these measure a business’s ability to generate profits relative to its revenue.
- Return on Equity = Net Income / Average Shareholder Equity. Measures the profits made for each dollar of shareholders’ equity.
- Gross Margin = Gross Profit / Net Sales. The profitability of a business after subtracting the cost of goods sold from the revenue.
Some include “turnover ratios”which measure how efficiently assets of a company are used to generate revenue, and “earning ratios”which measure returns that the company generates for its shareholders.
There is no single accounting ratio which tells the whole story.
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.