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Accounting Ratio

Accounting Ratio
BusinessCorporate Finance and AccountingFinancial Ratios

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 an approach to expressing the relationship between one accounting data point to another and are the basis of ratio analysis.

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.

Dissecting 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 be in every way determined by examining accounting ratios.

Accounting ratios additionally fill in as an important tool in company comparison inside an industry, for both the company itself and investors. A company can see how it stacks facing its peers and investors can use accounting ratios to determine which company is the better option.

An exhaustive accounting analysis can be a complex task, yet working out 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 additionally provides an overview of earnings and the number of shares outstanding used to calculate earnings per share (EPS). These are some of the most well known 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, assuming 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 extent 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, assuming 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 main measures of which is the debt-to-equity (D/E) ratio. It is calculated by dividing debt by equity. For example, in the event that 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 involving to finance operations as opposed to its own internal funds.

The Quick Ratio

The quick ratio, otherwise called 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 just 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. The two dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement.

For example, in the event that 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 delivers 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 a lot more that feature different aspects of a company.

Features

  • 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.
  • 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.
  • Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, gross margin, and operating margin.
  • 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.
  • 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.