Accounting ratios are those ratio comparisons that can be derived solely from the financial statements. They are used to form conclusions regarding the liquidity, leverage, profitability, and working capital usage of a business.
The essential accounting ratios are as follows:
Liquidity: The quick ratio is the best liquidity ratio. It compares all current assets except inventory to current liabilities. Inventory is excluded from the comparison, because it can be difficult to convert to cash. The purpose of the quick ratio is to see if a business has enough assets that can be reasonably converted into cash to meet its current obligations.
Leverage: The relative debt load of a business is its leverage, which is best measured with the debt-equity ratio. This ratio compares the total amount of all types of debt to the total amount of equity appearing on the balance sheet. The purpose of the debt-equity ratio is to see if a business is properly balancing the amount of funding raised from stock sales to the amount of funding raised from debt. A high ratio may not be supportable if a company’s cash flows are not consistent enough to make periodic interest and principal payments on its debt.
Profitability: The net profit ratio is the ultimate measure of profitability. It compares the net, after-tax earnings of a business to its net sales. The purpose of the ratio is to see if a business is being efficient with its expenditures to create products that can be sold at reasonable price points.
Working capital usage: The primary indicators of working capital usage are receivables turnover, inventory turnover, and payables turnover. High rates of turnover for receivables and inventory indicate that a company is maximizing its use of cash by having minimal assets outstanding in these areas. Conversely, a low payables turnover rate is considered better, since it implies that a business is maximizing the loans extended to it by its suppliers via outstanding invoices.
The ratio calculations are:
- Receivables turnover. Net annual credit sales divided by average receivables.
- Inventory turnover. Annual cost of goods sold divided by average inventory.
- Payables turnover. Annual purchases from suppliers divided by average payables.
All of these ratios can then be compared to the results from prior periods, as well as the same information reported by competitors, to judge the relative position of a company.