A great deal of work goes into your business's accounting, including keeping track of accounts receivable, accounts payable, inventory and many other transactions in your business. You can use accounting software to do a lot of the hard work for you, but it still behooves you to know the basics of accounting, which include accounting ratios.
Accounting ratios are quick ways to evaluate a business's financial condition. According to Accounting Scholar, ratios are the most frequently used accounting formulas in regards to business analysis. Analyzing your finances with these ratios can help you identify trends and other data that inform important business decisions.
Here are five of the most common ratio types and the various formulas you can use within each category:
- Liquidity ratios
- Profitability ratios
- Leverage ratios
- Turnover ratios
- Market value ratios
These ratios are used to calculate how capable a company is of paying debts, usually by measuring current liabilities and liquid assets. This determines how likely it is that your business will be able to pay off short-term debts. These are some common liquidity ratios:
- Current Ratio = Current Assets/Current Liabilities. The purpose of this ratio is to measure if your company can currently pay off short-term debts by liquidating your assets.
- Quick Ratio = Quick Assets/Current Liabilities. This ratio is similar to the current ratio, except that to measure "quick" assets, you only consider your accounts receivable plus cash plus marketable securities.
- Net Working Capital Ratio = (Current Assets - Current Liabilities)/Total Assets. By calculating the net working capital ratio, you're calculating the liquidity of your assets. An increasing net working capital ratio indicates that your business is investing more in liquid assets than fixed assets.
- Cash Ratio = Cash/Current Liabilities. This ratio tells you how capable your business is of covering your debts using only cash. No other assets are considered in this ratio.
- Cash Coverage Ratio = (Earnings Before Interest and Taxes + Depreciation)/Interest. The cash coverage ratio is similar to the cash ratio, but it calculates how likely it is that your business can pay your debts' interest.
Accountants use these ratios to measure a business's earnings versus its expenses. These are some common profitability ratios:
- Return on Assets = Net Income/Average Total Assets. The return on assets ratio indicates how much profit businesses make compared to their assets.
- Return on Equity = Net Income/Average Stockholder Equity. This ratio shows your business's profitability from your stockholders' investments.
- Profit Margin = Net Income/Sales. The profit margin is an easy way to tell how much of your income comes from sales.
- Earnings Per Share = Net Income/Number of Common Shares Outstanding. The earnings per share ratio is similar to the return on equity ratio, except that this ratio indicates your profitability from the outstanding shares at the end of a given period.
A leverage ratio is a good way to easily see how much of your company's capital comes from debt, and how likely it is that your company can meet its financial obligations. Leverage ratios are similar to liquidity ratios, except that leverage ratios consider your totals, whereas liquidity ratios focus on your current assets and liabilities.
- Debt to Equity Ratio = Total Debt/Total Equity. This ratio measures your company's leverage by comparing your liabilities, or debts, to your value as represented by your stockholders' equity.
- Total Debt Ratio = (Total Assets - Total Equity)/Total Assets. Your total debt ratio is a quick way to see how much of your assets are available because of debt.
- Long-Term Debt Ratio = Long-Term Debt/(Long-Term Debt + Total Equity). Similar to the total debt ratio, this formula lets you see your assets available because of debt for longer than a one-year period.
Turnover ratios are used to measure your income against your assets. There are many different types of turnover ratios. Here are some common turnover ratios:
- Inventory Turnover Ratio = Costs of Goods Sold/Average Inventories. The inventory turnover rate shows how much inventory you've sold in a year or other specified period.
- Assets Turnover Ratio = Sales/Average Total Assets. This ratio is a good indicator of how good your company is at using your assets to produce revenue.
- Accounts Receivable Turnover Ratio = Sales/Average Accounts Receivable. You can use this ratio to evaluate how quickly your company is able to collect funds from its customers.
Market value ratios
Market value ratios deal entirely with stocks and shares. Many of these ratios are used by investors to determine if your stocks are overpriced or underpriced. These are a couple of common market value ratios:
- Price-to-Earnings Ratio = Price Per Share/Earnings Per Share. Investors use the price-to-earnings ratio to see how much they're paying for each dollar earned per stock.
- Market-to-Book Ratio = Market Value Per Share/Book Value Per Share. This ratio compares your company's historic accounting value to the value set by the stock market.
Want to brush up on your basic accounting terms? Check out this infographic.