Meaning of Accounting Ratios and Their Purposes

Accounting ratios are metrics used to compare two or more financial data points from a company’s financial statements to measure its profitability, efficiency, and overall financial health. These ratios are typically expressed in various forms, such as proportions, fractions, percentages, or terms of the number of times one value relates to another.

Equation for Ratios:

Ratio = (Value of one item ÷ Value of another item) × 100

Examples of Ratios:

1. Gross Profit Ratio:
   1. Formula: (Gross Profit ÷ Net Sales) × 100
   1. Purpose: Evaluates the proportion of gross profit to net sales.
2. Return on Equity (ROE):
   1. Formula: (Net Income ÷ Shareholders’ Equity) × 100
   1. Purpose: Measures the profitability generated by shareholders’ investments.
3. Net Profit Ratio:
   1. Formula: (Net Profit ÷ Net Sales) × 100
   1. Purpose: Indicates a company’s overall financial health by showing net profit as a percentage of net sales. This ratio can be expressed in percentage, fractional, or decimal form.

Liquidity Ratios:

Liquidity ratios assess a company’s ability to meet short-term obligations. These ratios are often expressed in decimal form.

1. Debt-to-Equity Ratio:
   1. Formula: Total Debt ÷ Shareholders’ Equity
   1. Purpose: Measures the proportion of a company’s financing that comes from debt versus equity.
2. Current Ratio:
   1. Formula: Current Assets ÷ Current Liabilities
   1. Purpose: Evaluates a company’s ability to pay short-term obligations due within one year.

Activity Ratios:

Activity ratios measure how efficiently a company uses its assets to generate revenue and cash. These ratios are also referred to as efficiency ratios or turnover ratios.

1. Inventory Turnover Ratio:
   1. Formula: Cost of Goods Sold ÷ Average Inventory
   1. Purpose: Indicates how often inventory is sold and replaced during a given period. A high ratio is generally favorable.
2. Accounts Payable Turnover Ratio:
   1. Formula: Total Purchases ÷ Average Accounts Payable
   1. Purpose: Reflects how quickly a company pays off its suppliers.
3. Accounts Receivable Turnover Ratio:
   1. Formula: Net Credit Sales ÷ Average Accounts Receivable
   1. Purpose: Shows how efficiently a company collects payments from its customers.
4. Days Payable Outstanding (DPO):
   1. Formula: (Cost of Goods Sold ÷ Number of Days in Accounting Period)
   1. Purpose: Calculates the average number of days a business takes to pay its invoices and bills. The accounting period is usually 365 days.

Additional Ratios for Analysis:

To gain deeper insights into a company’s financial performance, you may explore the following ratios:

1. Capital Structure/leverage ratios of a firm
2. Profitability Ratios
3. Turn Over Ratios
4.  Debt service coverage ratio
5.  Benefit to cost ratio
6. Profit volume ratio (PV ratio)
7. Leverage ratio of assets to capital
8. Liquidity coverage ratio (LCR)
9. Provisioning coverage ratio
10. Net stable funding ratio NSFR
11. Limitation of ratio analysis explained
    
    

Purpose of Accounting Ratios:

Accounting ratios serve multiple purposes, including:

• Analyzing a company’s financial performance.
• Comparing a company’s performance with its competitors.
• Evaluating key aspects such as liquidity, profitability, and solvency.
• Helping stakeholders make informed decisions about investments and operations.

By using these ratios effectively, businesses and investors can draw meaningful conclusions about a company’s financial health and operational efficiency.