In this article, we’re going to dive into the world of accounting ratios, figure out what they mean, the different types of ratios, some popular formulae, the objectives of studying these ratios, and the different advantages they offer.
What are accounting ratios?
Accounting ratios compare two line items in a company’s financial statements, which comprise the income statement, the balance sheet, and the cash flow statement.
Accounting ratios are used to interpret the meaning of financial statements by comparing key items against other key items, hoping to reveal a pattern or signal in the way those metrics are behaving.
CTA: Ratio analysis
Types of accounting ratios
Accounting ratios can be categorised into four main buckets:
Profitability Ratios
These are the ratios that assess the company’s ability to generate profits from its operations. Key examples include:
- Gross profit margin: Measures the percentage of revenue remaining after accounting for the cost of goods sold.
Formula: (Gross Profit / Revenue) x 100 - Operating profit margin: Indicates the profitability of core business activities after factoring in operating expenses.
Formula: (Operating Profit / Revenue) x 100 - Net profit margin: Represents the ultimate profitability metric, reflecting the portion of each revenue dollar converted into net profit.
Formula: (Net Profit / Revenue) x 100
CTA: P/E Ratio
Liquidity Ratios
These ratios evaluate a company’s ability to meet its short-term financial obligations. Common examples include:
- Current ratio: Assesses a company’s ability to pay off short-term debts with its current assets.
Formula: Current Assets / Current Liabilities - Quick ratio: Provides a stricter measure of liquidity by excluding less liquid assets like inventory.
Formula: (Current Assets – Inventory) / Current Liabilities - Cash ratio: The most stringent liquidity measure, indicating the immediate ability to pay off short-term debts using only the most liquid assets.
Formula: Cash and Cash Equivalents / Current Liabilities
Solvency Ratios
These ratios measure a company’s long-term financial health and its ability to meet its long-term debt obligations. Examples include:
- Debt-to-Equity ratio: Indicates the proportion of debt financing compared to equity financing used by the company.
Formula: Total Liabilities / Shareholders’ Equity - Debt ratio: Expresses the percentage of a company’s assets financed by debt.
Formula: Total Debt / Total Assets - Interest Coverage ratio: Measures a company’s ability to cover its interest payments with its operating profits.
Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense
Efficiency Ratios
These ratios assess how effectively a company utilises its resources to generate sales and profits. Examples include:
- Inventory Turnover ratio: Measures how efficiently a company manages its inventory levels.
Formula: Cost of Goods Sold / Average Inventory - Accounts Receivable Turnover ratio: Indicates how effectively a company collects payments from its customers.
Formula: Net Credit Sales / Average Accounts Receivables - Asset Turnover ratio: Evaluates how efficiently a company generates revenue from its assets.
Formula: Revenue / Total Assets
Objectives and advantages of using accounting ratios
There are several reasons why accounting ratios are used:
- Assessing financial performance: Ratios help evaluate a company’s profitability, efficiency, liquidity, and solvency, providing a complete overall view of its financial health.
- Comparative analysis: By comparing a company’s ratios with industry averages or its own historical performance, you can identify trends and potential areas for improvement within this company. Ratios across companies in the same sector or industry tend to be in similar ranges.
- Investment decisions: Investors use ratios to assess the risk and potential return on investment in a company. ratios can indicate a company’s ability to generate profits, pay dividends, and meet its debt obligations.
- Credit analysis: Creditors and lenders analyse ratios to evaluate a company’s creditworthiness and ability to repay borrowed funds. This is crucial if a business wants to raise money to finance its operations or strategic growth opportunities.
- Financial forecasting: Ratios can also broadly analyse trends in specific industries and companies over time, helping analysts forecast future revenue growth, working capital requirements, or capital expenditures, which are then used to value the company’s future cash flows.
Limitations of Accounting Ratio Analysis
While accounting ratios provide valuable insights into a company’s financial health, they also come with certain limitations that should be considered when making decisions:
Historical data dependency
Accounting ratios rely on historical financial statements, which may not reflect the current or future performance of a company. For example, if a company has improved its operations after a poor financial year it may still show unfavorable ratios. This can mislead analysts into underestimating the company’s potential.
Lack of standardisation
Different companies may use different accounting policies and methods (e.g., depreciation methods), which can affect ratio comparisons. These discrepancies make it difficult to compare ratios across different businesses in the same industry.
Ignores qualitative factors
Ratios do not account for non-quantifiable aspects such as market trends, employee morale, or management quality. For instance, a company might have solid financial ratios, but if it faces intense competition or regulatory challenges, its long-term outlook may not be as strong as the numbers suggest.
One-dimensional focus
Ratios don’t provide a broad view of a company’s performance. A high liquidity ratio might indicate financial stability, but it could also suggest inefficiency in utilising resources.
Similarly, a company with a low debt ratio might be seen as a stable company, but it could be missing opportunities for growth by not leveraging debt effectively.
Impact of inflation
In developing countries like India, inflation rates can fluctuate and accounting ratios may not always prove to be accurate. Inflation affects the real value of assets and liabilities and can distort ratios like the return on assets or the debt-to-equity ratio.
Window dressing of financial statements
Sometimes, companies may manipulate their financial statements to present a better picture of their financial health, especially when they want to attract investors or secure loans. So, ratios derived from window-dressed financials may not provide an accurate assessment of a company’s true position.
Industry and seasonal variations
Ratios can vary widely between industries and even within the same industry during different seasons. For instance, a current ratio considered strong in one sector may not be accurate in another.
Industries such as textiles or agriculture are especially prone to seasonal fluctuations, which can affect their short-term liquidity and profitability ratios.
These limitations tell us that it is crucial to use accounting ratios alongside other analytical tools and qualitative assessments while evaluating a company’s performance.
Can a high ratio always be considered good?
Not necessarily. A high current ratio, for instance, might indicate excessive idle cash, which could be better utilised for investments. Context is key! Ratios are best analysed with industry benchmarks or historical trends.
How do I account for outliers when comparing ratios?
One-off events can skew ratios. Look beyond a single year’s data. Consider multi-year trends and industry medians to get a clearer picture.
What if a company doesn’t disclose all the data needed for a specific ratio?
This can happen very often with private companies in India. Estimate missing data points using industry averages or information from competitor reports, but be cautious and disclose your estimation methods for transparency.
Are there industry-specific ratios I should consider?
Absolutely! For example, the Debt-to-Equity Ratio might be less meaningful for a tech startup compared to a capital-intensive manufacturing company.
What about ratios for startups or young companies?
Traditional ratios might not paint the whole picture for startups with minimal assets or profits. Consider growth-oriented metrics like Customer Acquisition Cost (CAC) or Lifetime Value (LTV) alongside financial ratios.
