Financial statements contain financial information about a company’s financial situation.

Furthermore, in order to make important financial decisions, business owners, analysts, and other
stakeholders examine, compare, and interpret this financial data. However, such information is
interpreted using financial statement analysis tools and methodologies. One such popularly used
tool is accounting ratio analysis. In this article, we have covered each type of accounting ratios, their
formula, and importance of each ratio.

What are Accounting Ratios?

Accounting ratios are an important tool for analysing financial statements. It is a comparison of two
or more financial data that is used to analyse a company’s financial statements. These depict a
connection between two or more accounting numbers obtained from financial statements. It is a
useful tool for shareholders, creditors, and other stakeholders to understand a company’s
profitability, strength, and financial health. This is also known as financial ratios, which are used to
track corporate performance and make key business choices.

All of these sorts of ratios are used to track business performance and compare results to those of
competitors. Additionally, such ratios can be stated as a fraction, %, proportion, or number of times.
The financial statements determine the correctness and efficiency of accounting ratios as a financial
statement analysis tool. This is because the two or more accounting statistics used to calculate a
financial ratio are obtained from such statements. As a result, if the financial statements contain
incorrect data, the ratios will also portray an inaccurate analysis of the company’s financial results.

In addition, the accounting numbers used to calculate ratios should be related in some way. This is
because a financial examination of the company’s financial outcomes would be meaningless if the
statistics were unrelated.

Types of Accounting Ratios

Liquidity Ratios

Profitability Ratios

Solvency Ratios

Activity or Efficiency Ratio

Liquidity Ratios

The liquidity ratio is used to determine whether or not a company has enough cash on hand to pay
down its short-term debts. A high liquidity ratio indicates that the corporation will be able to pay its
creditors. It is allowed to have a liquid ratio of 2 or more.

Ratio Formula Objective

Current Ratio: Current assets include cash, inventory, accounts receivable or debtors, interest
receivable, etc

Current liabilities include accounts payable or creditors, income tax payable and any other current
liabilities {(Current Assets)/(Current Liabilities)} This is the most widely used liquidity ratio
for comparing a company’s current assets to its current liabilities.

The current ratio can be used to determine whether or not a company will be able to pay its debts in
the next twelve months.

Quick Ratio: Quick assets excludes assets such as inventory and prepaid expenses which are difficult
to liquidate quickly. {(Quick Assets)/(Current Liabilities)} Acid test is another name for Quick
Ratio. The quick ratio is a more cautious approach to determining a company’s short-term solvency.
It solely comprises the company’s quick assets, which are its most liquid assets.

Cash Ratio: The cash ratio is a ratio that compares a company’s total cash and cash equivalents to its
current liabilities. This metric represents a company’s ability to meet short-term debt obligations
with its most liquid assets. {(Cash + Marketable securities )/(Current Liabilities)} This ratio
converts current assets into an account that is immediately available to a company in order to pay its
liabilities. Any company with a Cash Ratio of one or greater is regarded as financially sound.

Profitability Ratio

Profitability ratios are a group of financial indicators that are used to evaluate a company’s ability to
create earnings over time in relation to its revenue, operational costs, assets, or shareholders’
equity. The evaluation is done by utilising financial information from a certain point in time.
Efficiency ratios assess how successfully a corporation uses its assets internally to generate income.
These efficiency ratios can be compared to profitability ratios (as opposed to after-cost profits).

Higher ratio outcomes are often more beneficial. However, such a ratio outcome must be compared
to

The results of similar companies

The company’s own previous performance

Industry average

Ratio Formula Objective

Gross Profit Margin: Revenue is the income from sale of goods or services

Cost of goods sold, as the name suggests, is the cost that a company incurs to produce the goods
that it sold. COGS includes raw materials, processing cost, labour, and other production expenses.
{(Revenue – Cost of Goods Sold (COGS))/(Revenue)}

Gross Profit = Revenue − Cost of Goods Sold Using the Gross Profit Ratio, any company can
compare its performance to that of its competitors or to that of its own historical performance.

The gross profit ratio expresses the proportion of factory costs to sales revenue.A higher gross profit
margin shows that a company’s operations are more efficient.
The Gross Profit Margin compares a company’s gross profit to its sales revenue. This margin shows
how much money a company makes after all of the costs of producing goods and services have been
deducted.

Operating Margin: Operating income is also known as EBIT earning before interest and taxes.

EBIT, or operational earnings = Revenue minus cost of goods sold (COGS) and normal selling,
general, and administrative costs of running a firm, excluding interest and taxes, {(Gross Profits-
Operating Expense)/(Revenue)} The operating margin quantifies how much profit a company
generates on a dollar of sales after paying for variable expenses. Such variable expenses include
production expenses, wages and raw materials, but before paying interest or taxes. Higher ratios
indicate that a company’s operations are efficient and that it is good at converting revenues into
profits.

Unlike Gross Profit Ratio, this includes more expenses and is thus used to more efficiently determine
a company’s profitability.

Profit Margin {(Revenue – Operating expense + non-operating income-Interest Expense- Income

taxes)/(Revenue)} Any business can determine the amount of profit gained from its entire
generated revenue using the Profit Margin ratio. A company’s overall profitability may be easily
assessed and compared to that of its competitors.

Earnings per Share (EPS): The net profit of a corporation is divided by the number of common shares
it has outstanding to calculate earnings per share (EPS)

Usually, weighted average number of outstanding shares is considered to calculate. This is because
the company issues shares during the year. Moreover, Diluted EPS covers options, convertible
securities and warrants outstanding which affects outstanding shares. {(Net Income – Preferred
Dividend)/(Weighted Average Outstanding Shares)} EPS is a widely used indicator for measuring
corporate value since it shows how much money a firm produces for each share of its stock.Investors
will pay more for a company’s shares if they believe the company’s profits are higher than its share
price, so a higher EPS signals more value.

The higher a company’s earnings per share (EPS), the more profitable it is deemed to be.

Solvency Ratios

A solvency ratio is a crucial metric used by prospective business lenders to assess an organisation’s
capacity to satisfy long-term debt obligations. A solvency ratio is a measure of a company’s financial
health that determines if its cash flow is sufficient to cover its long-term liabilities. An unfavourable
ratio can suggest that a corporation is at risk of defaulting on its debt obligations. Solvency ratios are
frequently utilised by prospective lenders and bond investors when evaluating a company’s
creditworthiness. Although both solvency and liquidity ratios are used to assess a company’s
financial health, solvency ratios have a longer-term outlook than liquidity ratios.

Ratio Formula Objective

Debt Equity Ratio or D/E ratio: Debt includes long term and short term debt obligations
Equity includes the shareholder’s capital i.e. value of outstanding shares plus reserves {(Total
Debt)/(Total Equity)} The D/E ratio is similar to the debt-to-assets ratio in that it shows how debt
is used to fund a company. The higher the ratio, the more debt a business has on its books, and the
greater the risk of default. The debt-to-equity ratio examines how much of the debt can be covered
by equity in the event of a liquidation.

This is also known as the gearing ratio. It is used by creditors and investors to assess a company’s
financial leverage.

Debt to Asset Ratio: Debt includes long term and short term debt obligations

Total assets is the total assets for the period as reflected in the balance sheet. {(Total Debt)/(Total
Asset)} The debt-to-assets ratio compares the overall debt of a corporation to its total assets. It
calculates a firm’s leverage and shows how much of the company is funded by debt vs assets.

It also measures the company’s ability to repay debt with available assets. A higher ratio, particularly
one above 1.0, suggests that a corporation is heavily reliant on debt and may struggle to satisfy its
obligations.

Debt Ratio {(Total Liabilities)/(Total Asset)} A debt ratio is a measurement of a company’s

indebtedness in terms of total debt to total assets.The debt ratio varies greatly by industry, with
capital-intensive enterprises having substantially greater debt ratios than others.A debt ratio more
than 1.0, or 100 percent, shows that a company’s debt exceeds its assets. On the other hand, a debt
ratio less than 100 percent implies that the company’s assets exceed its debt.

Interest Coverage Ratio: EBIT, or operational earnings = Revenue minus cost of goods sold (COGS)
and normal selling, general, and administrative costs of running a firm, excluding interest and taxes,
{(Earnings before interest and taxes (EBIT))/(Interest Expense)} The interest coverage ratio
determines how many times a company’s available earnings can cover its existing interest payments.
In other words, it calculates a company’s margin of safety for paying interest on its debt over a
specific time period. It is preferable to have a larger ratio. If the ratio falls below 1.5, it may suggest
that a corporation will have trouble paying its obligations’ interest.

Activity or Efficiency Ratio

Activity ratio determines the efficiency by which a company is utilizing its assets to generate revenue
and cash or bank balance. In other words, it calculates a company’s margin of safety for paying
interest on its debt over a specific time period.

Analysts can use activity ratios to assess a company’s inventory management, which is critical to its
operational flexibility and overall financial health. An activity ratio is a financial indicator that
investors and research analysts use to determine how well a firm uses its assets to create revenue
and cash.

Activity ratios can be used to compare two organizations in the same industry, or they can be used
to track the financial health of a single company over time.

Ratio Formula Objective

Accounts Receivable Ratio {(Annual Sales Credit) / (Accounts Receivable)} The ability of a
business to collect money from its clients is determined by the accounts receivable turnover ratio.
For a given period, total credit sales are divided by the average accounts receivable balance. A low
ratio indicates a problem with the collection procedure.

A high receivables turnover ratio may suggest that a company’s accounts receivable collection is
effective and that the company has a large number of high-quality customers who pay their bills on
time.Inefficient collection, poor credit policies, or clients that are not financially viable or
creditworthy could all contribute to a low receivables turnover percentage.

Inventory Turnover Ratio {(Cost of Goods Sold) / (Average Inventory)} The inventory
turnover ratio determines how frequently the inventory balance is sold over the course of a financial
year. The average inventory for a given period is divided by the cost of items sold. Higher
estimations indicate that a company’s inventory can be moved with relative ease.

Asset Turnover Ratio {(Net Revenue)/(Assets)} The assets turnover ratio is a metric that
assesses how effectively a company utilises its assets to make a sale. Total revenues are divided by
total assets to determine how well a company uses its resources. Smaller ratios could suggest that a
corporation is having difficulty moving its goods.

Objectives of Accounting Ratio Analysis

All stakeholders in a business must be able to interpret financial statements and other financial data.
As a result, ratio analysis becomes an important tool for financial analysis and management. The
following are the objectives of performing financial ratio analysis of an organization:

Measure the Profitability and Growth

Every company’s ultimate goal is to make money. So, if I tell you that ABC Company made a profit of
5 lakhs last year, how would you know whether it is a good or terrible figure? To quantify
profitability, context is essential, which is provided by ratio analysis. Gross Profit Ratios, Net Profit
Ratios, and Expense Ratios, among others, provide a gauge of a company’s profitability. Such ratios
can be used by management to identify and improve problem areas.

Evaluate Operational Efficiency of an Organization

Certain ratios reflect a company’s level of efficiency in managing its assets and other resources. To
avoid excessive expenditures, it is critical that assets and financial resources be allocated and used
wisely. Turnover and efficiency ratios will highlight any asset mismanagement.

Liquidity

Every company must ensure that part of its assets are liquid in case it needs money right now. As a
result, ratios like the current ratio and the quick ratio are used to assess a company’s liquidity. These
aid a company’s ability to sustain the necessary degree of short-term solvency.

Financial Strength
Some ratios can be used to determine a company’s long-term solvency. They can tell if a company’s
assets are being strained or if the company is over-leveraged. To avoid liquidation in the future,
management will need to immediately correct the situation. Debt-Equity Ratios, Leverage Ratios,
and other similar ratios are examples.

Comparison with Industry Standards and Competitors

To acquire a better picture of the organisation’s financial health and fiscal situation, the ratios must
be compared to industry standards. If the company fails to meet market criteria, the management
can take corrective measures. The ratios can also be compared to past years’ ratios to evaluate how
far the company has progressed. Trend analysis is the term for this.

Advantages of Accounting Ratio Analysis

Ratio analysis will assist in validating or disproving the firm’s finance, investment, and operational
decisions. They convert the financial statement into comparison statistics, allowing management to
assess and evaluate the firm’s financial status and the outcomes of their decisions.

Complex accounting statements and financial data are reduced to simple ratios of operating
efficiency, financial efficiency, solvency, long-term positions, and so on.

Ratio analysis assists in identifying issue areas and drawing management’s attention to them. Some
information is lost in the complicated accounting statements, and ratios will aid in identifying these
issues.

Allows the company to compare itself to other companies, industry standards, and intra-firm
comparisons, among other things. This will assist the firm in gaining a better understanding of its
financial situation in the economy.

Limitations of Accounting Ratio Analysis

The data utilised in the analysis is based on the company’s own published prior results. As a result,
ratio analysis indicators are not always indicative of future firm performance.

Because financial statements are released on a regular basis, there are time gaps between them.
Real prices are not represented in the financial accounts if inflation has occurred between periods.
As a result, until the figures are corrected for inflation, they are not comparable across time periods.

If the company’s accounting standards and practices have changed, this could have a significant
impact on financial reporting. The key financial indicators used in ratio analysis are changed in this
scenario, and the financial outcomes reported after the change are not comparable to those
recorded before the change. It is the analyst’s responsibility to keep up with changes in accounting
policies. The notes to the financial statements section usually contain the changes made.

A company’s operational structure, from its supply chain strategy to the product it sells, may
undergo major changes. When a firm undergoes significant operational changes, comparing financial
measures before and after the change might lead to inaccurate inferences about the company’s
success and future prospects.
Seasonal influences should be considered by analysts because they can lead to ratio analysis
constraints. Due to the inability to alter the ratio analysis for seasonality effects, the results of the
analysis may be misinterpreted.

The information given by the corporation in its financial accounts is the basis for ratio analysis. This
data could be modified by the company’s management to show a greater performance than it
actually has. As a result, ratio analysis may not adequately reflect the underlying nature of the firm,
because information misrepresentation is not detectable by basic analysis. It is critical for an analyst
to be aware of these potential manipulations and to conduct thorough due diligence before drawing
any conclusions.

These limiting factors are as follows:

(i) Ratios are not end in themselves but they are means to achieve a particular end.

(ii) The accuracy and correctness of ratios are totally dependent upon the reliability of the data
contained in financial statements on the basis of which ratios are calculated.

(iii) The analyst or the user must have comprehensive but practical knowledge and experience about
the concerns whose statements are used for calculating ratios.

ADVERTISEMENTS:

(iv) In case of inter-firm comparison, there must be uniformity in the accounting plan used by both
the firms.

(v) Ratios may make the comparative study complicated and misleading on account of changes in
price level.

(vi) Inter-firm comparison through ratio analysis should not be undertaken in the case of concerns
which are not associated or comparable.

The importance of ratio analysis is discussed hereunder:

(a) It helps to analyse the probable casual relation among different items after analysing and
scrutinizing the past result.
(b) The ratios that are derived after analysing and scrutinizing the past result, helps the management
to prepare budgets, to formulate policy, and to prepare the future plan of action and thus helps as a
guide to harmonize among different items for preparing budgets.

(c) It helps to take time dimension into an account by trend analysis, i.e., whether the firm is
improving or deteriorating over a number of years, that can easily be studied by the trend analysis.
So, comparison can be made without difficulty by the analyst and to see whether the said ratio is
high or low in comparison with the Standard or Normal ratio.

ADVERTISEMENTS:

(d) It throws light on the degree of efficiency of the management and utilization of the assets and
that is why it is called surveyor of efficiency.

(e) It helps to make an inter-firm comparison either between the different departments of a firm or
between two firms employed in the identical types of business or between the same firm of two
different dates. Thus, the comparative analysis can be possible between the industry average ratio
and the ratio of each business unit.

(f) Short-term liquidity position, i.e., whether the firm is able to maintain its short-term maturing
obligations or not, that can be easily known by applying liquidity ratios. At the same time, long-term
solvency position can also be measured by the application of leverage or profitability ratios. Thus,
the ratio helps an invaluable aid to the users of Financial Statements.

4. Limitations of Financial Ratio Analysis:

The ratio analysis is not even free from snags.

There are certain limitations which are discussed below:

(a) Comparison between two variables prove worth provided their basis of valuation is identical. But
in reality, it is not possible, such as, methods of valuation of stock-in-trade or charging different
methods of depreciation on fixed assets etc. That is, if different methods are followed by different
firms for their valuation, in that case, comparison will practically be of no use.

(b) Ratio depends on figures appeared on the Financial Statements. But in most cases, the figures are
window dressed. As a result, the correct picture cannot be drawn up by the ratio analysis, although
certain structural defects can be detected.
(c) Ratio analysis becomes more meaningful and significant if trend analysis (i.e. the analysis over a
number of years) is possible instead of analysing the result of a particular year. But is practice, it is
not always possible

(d) Ratios are computed on the basis of past result. It does not help properly to predict future, to
prepare budgets and estimates since the business policies are constantly changing.

(e) It is very difficult to ascertain the Normal or Standard ratio in order to make proper comparison.
Because, it differs from firm to firm, industry to industry and even between different seasons of the
same industry. Besides, it may be happened that in one firm, a current ratio of 1 : 1 is found to be
quite satisfactory, whereas in another firm 25: 1 may even be unsatisfactory

5. Interested Parties in Financial Ratio Analysis:

People in various walks of life are at present interested in ratio analysis though in different ways and
fashion and each, however, from his own angle. Shareholders are interested to know the rates of
return on capital employed the long-term solvency of the firm and also on the rates of dividend
among others.

The same they can ascertain with the help of Gross Profit Ratio, Net Profit Ratio, Dividend Per Share,
Earning Per Share etc.

Creditors’ interest lie in the ultimate solvency and liquidity position of a firm and in the interest
cover. These they can read from the analysis of Current ratio. Liquid ratio, Debt-Equity ratio etc.
Government is interested in profit earning capacity and on the effective utilisation of firm’s capacity.

Therefore, Gross Profit Ratio, Ratio of Net profit to Capital Employed, Net Profit to Sales, production
capacity utilisation etc. are of much relevance to a Government.

Management is interested about profitability and efficiency in Financial Management. Therefore, to

it, the Ratio between Turnover to Capital Employed, Turnover to Fixed Assets, Turnover to Current
Assets, Stock-Turnover Ratio, Debtors’ Turnover Ratio, Creditors’ Turnover Ratio etc. are of
significance to the management.

The ratios of social investigators will depend on area of his investigation. If the investigators’ interest
lie in the analysis of turned of financing obtaining in a corporate enterprise over a period of time, the
Ratio between Debt and Equity, Long-term and Short-term debts and total assets among others, will
be relevant ratios for the investigation.