Accounting Ratio Definition and Different Types (2024)

What Is an Accounting Ratio?

Accounting ratios, an important sub-set of financial ratios, are a group of metrics used to measure the efficiency and profitability of a company based on its financial reports. They provide a way of expressing the relationship between one accounting data point to another and are the basis of ratio analysis.

Key Takeaways

  • Accounting ratios, an important sub-set of financial ratios, are a group of metrics used to measure the efficiency and profitability of a company based on its financial reports.
  • An accounting ratio compares two line items in a company’s financial statements, namely made up of its income statement, balance sheet, and cash flow statement.
  • These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.
  • Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, gross margin, and operating margin.
  • Accounting ratios are used by both the company itself to make improvements or monitor progress as well as by investors to determine the best investment option.

Understanding an Accounting Ratio

An accounting ratio compares two line items in a company’s financial statements, namely made up of its income statement, balance sheet, and cash flow statement. These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.

Analyzing accounting ratios is an important step in determining the financial health of a company. It can often point out areas that are bringing the profitability of a company down and therefore need improvement. The efficacy of new management plans, new products, and changes in operational procedures, can all be determined by analyzing accounting ratios.

Accounting ratios also work as an important tool in company comparison within an industry, for both the company itself and investors. A company can see how it stacks up against its peers and investors can use accounting ratios to determine which company is the better option.

A thorough accounting analysis can be a complex task, but calculating accounting ratios is a simple process of dividing two line items found on a financial statement, that provide a quick form of clear analysis to a business owner or investor.

Types of Accounting Ratios

Gross Margin and Operating Margin

The income statement contains information about company sales, expenses, and net income. It also provides an overview of earnings and the number of shares outstanding used to calculate earnings per share (EPS). These are some of the most popular data points analysts use to assess a company’s profitability.

Gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. The higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion of revenues as profit rather than expenses.

Operating profit as a percentage of sales is referred to as operating margin. It is calculated by dividing operating profit by sales. For example, if the operating profit is $60,000 and sales are $100,000, the operating profit margin is 60%.

Debt-To-Equity Ratio

The balance sheet provides accountants with a snapshot of a company’s capital structure, one of the most important measures of which is the debt-to-equity (D/E) ratio. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1. The debt-to-equity ratio shows how much a business is leveraged; how much debt it is using to finance operations as opposed to its own internal funds.

The Quick Ratio

The quick ratio, also known as the acid-test ratio, is an indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we're only concerned with the most liquid assets, the ratio excludes inventories from current assets.

Dividend Payout Ratio

The cash flow statement provides data for ratios dealing with cash. For example, the dividend payout ratio is the percentage of net income paid out to investors through dividends. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement.

For example, if dividends are $100,000 and income is $400,000, the dividend payout ratio is calculated by dividing $100,000 by $400,000, which is 25%. The higher the dividend payout ratio the higher percentage of income a company pays out as dividends as opposed to reinvesting back into the company.

The examples above are just a few of the many accounting ratios that corporations and analysts utilize to evaluate a company. There are many more that highlight different aspects of a company.

Accounting Ratio Definition and Different Types (2024)

FAQs

What are the different types of accounting ratio? ›

The accounting ratios or ratios in management accounting have four ratios: liquidity ratios, activity ratios, solvency ratios, and profitability ratios.

How do you explain ratios in accounting? ›

Accounting ratio is the comparison of two or more financial data which are used for analyzing the financial statements of companies. It is an effective tool used by the shareholders, creditors and all kinds of stakeholders to understand the profitability, strength and financial status of companies.

What are the four categories of ratios explain? ›

In general, there are four categories of ratio analysis: profitability, liquidity, solvency, and valuation. Common ratios include the price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity (D/E). Financial ratios are essential to solid fundamental analysis.

What are financial ratios and types? ›

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries.

What are the 5 major categories of ratios? ›

The following five (5) major financial ratio categories are included in this list.
  • Liquidity Ratios.
  • Activity Ratios.
  • Debt Ratios.
  • Profitability Ratios.
  • Market Ratios.

What are the five types of ratios? ›

Financial ratios are grouped into the following categories:
  • Liquidity ratios.
  • Leverage ratios.
  • Efficiency ratios.
  • Profitability ratios.
  • Market value ratios.

What are the 3 main categories of ratios in accounting? ›

Although there are many financial ratios businesses can use to measure their performance, they can be divided into four basic categories.
  • Liquidity ratios.
  • Activity ratios (also called efficiency ratios)
  • Profitability ratios.
  • Leverage ratios.

How to calculate ratios? ›

Since ratios compare data between two numbers of the same kind, this means your formula would be A divided by B. For instance, if A equals 5 and B equals 10, then your ratio will be 5 divided by 10.

How to solve ratios? ›

Solving Ratio Word Problems
  1. Identify the known ratio and the unknown ratio.
  2. Set up the proportion.
  3. Cross-multiply and solve.
  4. Check the answer by plugging the result into the unknown ratio.

What is a ratio for dummies? ›

A ratio is an ordered pair of numbers a and b, written a / b where b does not equal 0. A proportion is an equation in which two ratios are set equal to each other. For example, if there is 1 boy and 3 girls you could write the ratio as: 1 : 3 (for every one boy there are 3 girls)

What are the 4 most commonly used categories of financial ratios? ›

Assess the performance of your business by focusing on 4 types of financial ratios:
  • profitability ratios.
  • liquidity ratios.
  • operating efficiency ratios.
  • leverage ratios.
Dec 20, 2021

What is a ratio for beginners? ›

A ratio shows how much of one thing there is compared to another. If you are making orange squash and you mix one part orange to four parts water, then the ratio of orange to water will be 1:4 (1 to 4).

What are key financial ratios? ›

There are six basic ratios that are often used to pick stocks for investment portfolios. Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).

What is a good quick ratio? ›

Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.

What are the 3 main categories of ratios? ›

There are three broad categories of financial ratios: liquidity, solvency, and profitability. Discuss what each category reveals about the company being analyzed.

What are the different types of profit ratios? ›

There are two main types of profitability ratios: margin ratios and return ratios. Margin ratios measure a company's ability to generate income relative to costs. Return ratios measure how well a company uses investments to generate returns—and wealth—for the company and its shareholders.

What are the three uses of accounting ratio? ›

Helps to measure the profitability and operating efficiency of a firm. Proves effective in gauging the short-term financial standing of a firm. Enables to identify future trends of business and subsequently helps formulate an effective budget.

References

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