What is an accounting ratio?

Accounting ratios are a key subset of financial ratios that help express the relationship between accounting data points. They are considered the basis of ratio analysis used to measure the efficiency and profitability of a business. 

In a company’s financial statements, an accounting ratio draws a comparison between two-line items. Let’s dive into the meaning of accounting ratio in more detail. 

An accounting ratio is a group of metrics employed for measuring efficiency and profitability. Companies and investors use accounting ratios to monitor progress and consider the best investment option.

Accounting ratios can be used to compare two line items in a company’s financial statements from its income statement, balance sheet and cash flow statement. This helps management determine the company’s financial health, evaluating its fundamentals and comparing performance over a certain period, especially in previous quarters or fiscal years.

Through the analysis of accounting ratios, management can also determine new products, management plans and changes in operational procedures. Investors can use accounting ratios to select a company from the industry by comparing accounting ratios among their peers, enabling them to make more informed investment options. 

A detailed accounting analysis is a complex and time-consuming task; calculating and making an analysis based on accounting ratios is simpler.

Types of accounting ratios

A key in being able to define accounting ratios is knowing the different types. They can be widely classified under four categories: 

• Liquidity ratio measures a company’s cash sufficiency. A liquidity ratio of 2 or more is considered acceptable and means the company is in a good position to pay its creditors. This category includes current ratio, quick ratio and cash ratio. 

• Profitability ratio consists of the gross profit margin, operating margin, profit margin and earnings per share (EPS). These demonstrate how well the business is generating profits from its operations. 

• Leverage ratio measures the utilisation of a company’s borrowed money along with its financial stability and total debt. It includes the debt ratio, debt-to-equity ratio, debt-to-asset ratio and interest coverage ratio.

• Efficiency ratio, also called activity ratio, highlights the return generated from an asset, helping identify effective utilisation and efficient management. Receivable ratio, inventory turnover ratio and asset turnover ratio are part of this category.

How to calculate accounting ratio

Below is a list of the individual ratios and the formulas to calculate them. 

• Current ratio = current assets / current liabilities

• Quick ratio = (current assets - inventory - prepaid expenses) / current liabilities

• Cash ratio = (cash + marketable securities) / current liabilities

• Gross profit margin = (revenue - cost of goods sold) / revenue

• Operating margin = (gross profits - operating expense) / revenue

• Profit margin = (revenue - operating expense + non-operating income - interest expense - income taxes) / revenue

• EPS = (net income - preferred dividend) / weighted average outstanding shares

• Debt-to-equity ratio = total debt or liabilities / total equity

• Debt ratio = total liabilities / total assets

• Interest coverage ratio = earnings before interest and taxes (EBIT) / interest expense

• Inventory turnover ratio = cost of goods sold / average inventory

• Asset turnover ratio = net revenue / assets

• Receivable ratio = annual sales credit / accounts receivable