What Is a Financial/Accounting Ratio?
A ratio is a relationship between two quantities, attained by dividing one quantity by the other.
Financial/accounting ratios help analysts make meaningful comparisons between one firm’s financial data at different points in time and that of other companies.
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 resulting ratio, or the percentage, carries meaning and usefulness for decision-making purposes.
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 such as income statements and balance sheets are of limited value as sources of information. This is because they only summarize what has happened in a business using certain accounting conventions.
For example, a reported profit of $50,000 or a sales figure of $100,000 conveys very little about the performance of a company. However, 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 to benchmarks. Benchmarks show the trend of a ratio over time, or they could be industry averages for firms of a similar size, background, or other characteristics.
Hence, some important aspects to keep in mind when analyzing accounting ratios are:
- Ratios considered alone mean very little—they should be compared with other ratios, norms, standards, etc.
- Analysts should decide which ratios are appropriate in a specific situation and what combination of ratios to use
- Ratios give clues about the strengths and weaknesses of a company
Classification of Accounting Ratios
Accounting or financial ratios can be broadly classified into two groups:
- Performance-related ratios
- 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.
They are intended to help the management assess the effectiveness of the company’s pricing policy, stock carrying, and speed of stock turnover.
The 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 company’s overall profitability. 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 fall into two sub-groups: capital-related ratios and liquidity-related ratios.
These ratios relate to the company’s capital structure. 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 reflect the company’s ability to meet its current liabilities out of current assets. The most commonly used liquidity ratios are: