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:

  1. Ratios considered alone mean very little—they should be compared with other ratios, norms, standards, etc.
  2. Analysts should decide which ratios are appropriate in a specific situation and what combination of ratios to use
  3. 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:

  1. Performance-related ratios
  2. Position-related ratios

Performance-related ratios

Performance-related ratios can be further classified into three groups: trading ratios, profitability ratios, and dividend ratios.

Trading 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:

Profitability ratios

As the name implies, these ratios help management in assessing the company’s overall profitability. The important profitability ratios are:

Dividend ratios

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 fall into two sub-groups: capital-related ratios and liquidity-related ratios.

Capital-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:

Liquidity-related ratios

These ratios reflect the company’s ability to meet its current liabilities out of current assets. The most commonly used liquidity ratios are:

Frequently Asked Questions

What are Financial Ratios?

Financial Ratios are some standard measurements that allow users to compare the financial health of different companies. Financial Ratios are used by investors, creditors, auditors and others to analyze what they consider important about a company's financial status. There is no specific formula for calculating any one ratio nor is it limited to a specific number of ratios that can be reported.

What is the most important ratio?

The answer as to which ratio is the most important depends heavily on what information you wish to obtain from it. If you are trying to determine if a company has sufficient cash and assets available to meet its current obligations, the current ratio would be an ideal measure for comparison with other companies in similar industries and markets.

Are ratios an accurate indication of how well a company is doing?

Financial ratio analysis does not reflect the whole picture with regards to financial health of a company. Accountants can manipulate the numbers within ratios to produce desired results. For example, reducing Accounts Receivable by offering trade discounts can improve the current ratio but at the expense of future Cash Flow.

How many ratios are there?

There really is no limit on how many ratios you could create for comparison purposes. The most common though is 10, including (1) profitability, (2) liquidity, (3) position and (4) Cash Flow.

Is there a formula for Financial Ratios?

There is no single formula to calculate the ratios, however each ratio has its own calculation. Each company's numbers are different meaning that their ratios will also be different.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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