Accounting Ratios and Formulas: The Basics You Need to Know
Ratio can be defined as the relationship that exists between two figures. Accounting ratios are used in the interpretation of financial statements and they provide means by which various items in the final account are compared to other items. It will be considered under the following heading:
- Profitable ratio
- Liquidity ratio
- Investment ratio
- Leverage ratios
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The profitability ratio measures the profit earned over the period and capital employed at the end of the year. This will show the effectiveness of the management team.
1. Gross profit percentage
This is the relationship between the profit and selling price.
Gross profit divided by Sales multiplied by 100
Fluctuation can occur in the ratio when there is changes in selling prices, volume of output and changes in stock valuation basis.
2. Net profit percentage
It shows whether or not the expenses of running the business are in proportion to the amount of trade.
Net profit after tax divided by (Sales multiplied 100%)
Net profit after tax
Sales X 100%
3. Return on Capital employed
This is the yardstick employed to measure the efficiency of the management in utilizing the assets of the business.
Profit divided by Capital employed multiplied by 100%
Profit X 100%
Capital employed
4. Turn over Ratio
This is the ratio that shows how a company has been able to utilize its assets to generate sales. A low rate shows that a company is not generating sufficient volume of business for the size of her investment. This may be due to inefficiency in the production planning and control.
Sales divided by Capital employed
Sales
Capital employed
LIQUIDITY RATIO
This ratio measures the extent to which the business can meet its short term obligations or pay its debt as they fall due.
1. Current ratio or Working capital ratio
It indicate the strength of the working capital and the degree of solvency of the business. The ratio shows the extent to which the claim of creditors can be quickly met.
Current ratio = Current assets divided by Current liabilities
Current ratio = Current assets
Current liabilities
A low ratio indicates lack of working capital and a high ratio indicates that too much capital is tied up in stocks.
2. Liquid ratio or Acid test ratio
This is a better test of the short term solvency of the business of the length of the time often necessary to convert stocks into cash.
Current assets - Stock divided by Current liabilities
Current assets - Stock
Current liabilities
3. Rate of Stock Turnover
The ratio shows the number of times stock is turned over within the period. The average stock must be taken to be opening stock plus closing stock divided by two.
Cost of goods sold divided by Average stock
Cost of goods sold
Average stock
4. Stock on current assets
This shows the importance of stock as percentage of current asset.
Stock divided by Current assets multiplied by 100%
Stock X 100%
Current assets
5. Debtors ratio
This ratio shows the average credit period taken from suppliers.
Debtors divided by Credit sales multiplied by 365 days
Debtors X 365 days
Credit sales
6. Creditors ratio
This shows the average credit period taken from suppliers
Creditors divided by Credit purchase multiplied by 365 days
Creditors X 365 days
Credit purchases
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INVESTMENT RATIO
The investment ratio is used by investors in evaluating the share quoted companies as potential investment.
1. Price earning ratio
This expresses the market price of the shares as the number of years of its current earning
Quoted price of one share divided by Earning per share
Quoted price of one share
Earning per share
A high price earning ratio means that investors expect the profit of the company to grow
2. Dividend yield
This is an indication of the yield an ordinary share shareholder would receive if the profit were divided
Dividend per Share divided by Share price multiplied by 100%
Dividend per share X 100%
Share price
3. Dividend Cover
This is known as pay out ratio. It compares the earnings per share to the dividend per share and indicate the extent to which the earning are being retained or invested back into the business
Profit after tax divided by Total dividend OR Earning per share divided by Divided by share.
Profit after tax
Total dividend
OR
Earning per share
Divided by share
Leverage ratios
leverage ratio is a way to easily calculate how much of your company's capital comes from debt and the likelihood that your company can meet its financial obligations. Leverage ratios are similar to liquidity ratios, the difference is that leverage ratios focus on your totals, whereas liquidity ratios consider your current assets and liabilities.
- Debt-to-Equity Ratio = Total Debt/Total Equity: This ratio measures your company's leverage by comparing your liabilities, or debts, to your value as represented by your stockholders' equity.
- Total Debt Ratio = (Total Assets - Total Equity)/Total Assets: Your total debt ratio is a quick way to see how much of your assets are available because of debt.
- Long-Term Debt Ratio = Long-Term Debt/(Long-Term Debt + Total Equity): Similar to the total debt ratio, this formula lets you see your assets available because of debt for longer than a one-year period.
