A. Liquidity Ratios

What are Accounting Ratios?

Accounting ratios are the quantifiable or numerical connection between two accounting data used to assess a company’s performance. Ratios are used to compare many aspects of a company, such as revenue, liquidity, solvency, and efficiency, and can be stated as a percentage, fraction, or decimal. Accounting ratios are those that are determined using financial data documented in a company’s financial statements....

Types of Accounting Ratios with Formulas

Accounting ratios are broadly classified into 4 parts:...

A. Liquidity Ratios

1. Current Ratio: Current ratio is one of the two main liquidity ratios. It is a very important accounting ratio that is used to depict the magnitude of current assets against current liabilities of a concern. The objective is to determine whether the firm holds enough current assets to pay off its current obligations, i.e., short-term liabilities or not. A higher current ratio implies that the firm can easily convert its assets into cash to pay off its dues and vice-versa. The creditors of a firm use the current ratio to ensure that the firm has enough resources to pay them back or not. It is also known as Working Capital Ratio and is given as:...

B. Solvency Ratios

1. Debt-Equity Ratio: Debt-Equity Ratio is used to compare the magnitude of long-term debt and shareholders’ equity in the firm. The objective is to find the extent to which each of the sources has been utilized to raise funds by the firm, by comparing the magnitudes of both. A higher debt-equity ratio shows the firm in a risky position since it means that the firm owes more to the outside parties, whereas a lower debt-equity ratio means the firm has lower outside sources for raising funds and that its equity capital is sufficient. Debt-Equity Ratio is calculated by the following formula:...

C. Activity Ratios

1. Inventory Turnover Ratio or Stock Turnover Ratio: The efficiency of a product-based business is measured by the rate at which it is able to convert its inventory into sales. This measurement is done with the help of the Inventory Turnover Ratio or Stock Turnover Ratio, which is a very important turnover ratio. The Inventory Turnover Ratio is used to express the relationship between the cost of goods sold and the inventory held by the firm. It depicts the number of times a firm was able to convert its inventory into sales in a given accounting period. A higher Stock Turnover Ratio implies the fast movement of goods and fast sales, whereas a lower stock turnover ratio means stagnant sales and that goods are stacked up in warehouses. The Inventory Turnover Ratio is calculated by the following formula:...

D. Profitability Ratios

1. Gross Profit Ratio: It is a financial metric, which establishes a relationship between the gross profit of a company and its net revenue from operations. It is used to determine the profit earned by a firm after bearing all its direct expenses, i.e., the expenses directly tied to production. This ratio is used to determine the earning efficiency of the firm. Generally, a higher gross profit ratio indicates an increase in the profit margin. Gross profit ratio can be compared with the previous year’s ratio of the firm or with similar firms to see if it is up to the mark. It is calculated as:...