What is the financial/accounting ratio?
A ratio is a relationship between two quantities by dividing one quantity by another. Financial/accounting ratios help the analyst in making meaningful comparisons of a firm’s financial data at different points of time and with other firms.
An accounting ratio is simply one accounting figure expressed in terms of another. To calculate a ratio, therefore, one needs two figures. These two figures should be very carefully selected so that the resultant ratio, or the percentage, could carry meaning and be useful for decision making purpose. A ratio may take any of the following forms:
- a percentage (e.g. gross profit as a percentage of sales)
- a fraction (e.g. working capital as a fraction of capital employed)
- a number (e.g. rate stock turn)
- a proportion (e.g. current assets to current liabilities)
Analysis of accounting ratios:
Financial statements like the Income Statement and the Balance Sheet are of limited value as sources of information because they simply summarize what has happened by using certain accounting conventions.
A profit of $50,000 or a sales of $1,00,000 may convey very little about the performance of a company. But if these figures are expressed as ratios, in the form of a percentage or a rate, then they have more meaning. Also, ratios have more meaning when compared with some benchmark. The benchmark could be the trend of a ratio over time, or it could be an industry average for firms of the same size or company background and so on.
Hence some important aspects which should be kept in mind when analyzing accounting ratios are:
- Ratios taken alone mean very little. They should be compared with other ratios, norms, standards, etc.
- The analyst should decide the ratios which are appropriate in a specific situation and what combination of ratios to use.
- Ratios give clues about the strengths and weakness of a firm.
Classification of accounting ratios:
Accounting or financial ratios can be broadly classified into two groups:
- Position related ratios.
Performance-related ratios can be further classified into three groups: Trading ratios, profitability ratios and dividend ratios.
These ratios relate to the trading aspect of the business and are intended to help the management to assess the effectiveness of the company’s pricing policy, stock carrying, and speed of stock turnover. Main trading ratios are:
- Gross profit ratio
- Rate of stock turnover
- Total assets turnover ratio
- Operating assets turnover ratio
As the name implies, these ratios help management in assessing the overall profitability of the company. The important profitability ratios are:
- Return on equity ratio
- Return on capital employed ratio
- Net profit ratio
- Gross profit ratio
- Earnings per share ratio
- Price earnings ratio
- Earnings yield rate
Dividend ratios disclose the company’s dividend policy, i.e., to what extent does it distribute or retain its profits.The ratios include:
- Dividend declared as a percentage of after-tax profit
- Dividend cover for preference shares
- Dividend cover for ordinary shares
- Dividend yield ratio
Position related ratios:
Position related ratios also have two main sub-groups: capital related ratios and liquidity related ratios.
Capital related ratios:
These ratios relate to the capital structure of the company. They show the relationship of each class of capital employed to the total capital employed. The important capital ratios are:
- Equity as a percentage of capital employed
- Borrowed capital as a percentage of capital employed
- Capital gearing ratio
- Gearing level
- Interest coverage ratio
- Fixed assets as a percentage of capital employed
- Working capital as a percentage of capital employed
These ratios show the company’s ability to meet its current liabilities out of current assets. Mostly used liquidity ratios are:
- Current ratio
- Quick ratio or acid test ratio
- Debtors turnover ratio
- Average collection period
- Average payment period
- The average stock retention period
- Working capital cycle