Accounting ratios, also known as financial ratios, are the relationships between two or more financial data used to analyze a company’s financial position or any other legit business operation.

Values used to calculate accounting ratios are always retrieved from the income statements, balance sheet, statements of change in equity, and cash flow statements. All these combined constitute the company’s financial statements.

The ratios taken from such statements are either expressed in decimal, e.g., 0.2, or a percentage like 2%, depending on the accountant’s preference.

**What are the 5 Types of Accounting Ratios? **

The following are the five major types of accounting ratios and how they are applied;

**Liquidity Ratios**

This type of ratio is used to check whether the business or the company has the capacity to pay its short-term liabilities. This tool is essential to a company as it helps evaluate the ability of a company to meet its short-term activities. Higher liquidity ratios signal an excellent company’s financial position.

The liquidity ratio is further divided into;

- Net-working capital
- Quick ratio/acid test ratio
- Current ratio
- super-quick ratio
- Cash flow from operation ratio.

The formulae used in liquidity ratio are;

**Current Ratio = Current Assets/Current Liabilities****Quick Ratio = [Current Assets – Inventory – Prepaid Expenses] / Current Liabilities**

**Debt to equity ratio**

Unlike the liquidity ratio, this type of ratio is used to determine the long-term debt-paying capacity of a company or business. It looks at how much the business relies on debts to carry out its activity and the ability to repay such debts.

The debt to equity ratio, also known as the solvency or leverage ratio, is majorly used to look at the overall debt and compare its capital injected by the investors. Here, the lower value is always safer, but the entrepreneur or the investor should always be cautious.

Other types under this ratio are;

- Debt to asset ratios
- Fixed asset ratios
- propriety ratio
- interest-coverage ratio.

The formulae used here are as follows;

**Debt-to-Equity Ratio = Liabilities / Shareholder Equity (total)****Debt Ratio = Total Liabilities/Total Assets**

**Activity Ratios**

Activity ratios can also be termed efficiency ratios, turnover ratios, or performance ratios. They are an important tool of financial ratios as they indicate its efficiency.

These ratios show how the company uses its available resources like assets to escalate sales. They symbolize the speed at which the business or a company makes sales.

The following Are the major types of Activity ratios

- Working capital turnover ratio
- Fixed asset turnover ratio
- Stock or inventory turnover ratio
- Receivable or debtor’s turnover ratio

To develop inventory turnover, you will take the cost of goods sold in that particular year and divide it by the average inventory. This will bring a clear picture of how the company manages its assets in relation to its sales.

On the other hand, the Receivable or debtor’s turnover ratio indicates how fast net sales are turned into liquid cash. It is the net sales divided by average accounts receivables.

**Profitability Ratios**

Also known as the performance ratio, the profitability ratio indicates the company’s profit. They give out a clear picture of how the company is making a profit at various stages of operations.

They include; net profit margin, return on equity, operating profit margin, gross profit margin, and return on assets.

The gross profit shows sales compared to profit, while the operating profit margin shows the company’s profit before taxes and interests payments.

A high ratio is a representation of high return in the company and how better the company is. The following are the commonly used formulae on profitability ratio;

**Return on Equity = Net Income / Average Shareholder Equity****Gross Margin = Gross Profit / Net Sales****Return on Assets = Net Income/Total Assets**

**Valuation Ratios**

Also known as the market ratio, valuation ratios gauge the company’s ability or strength in the market. They majorly depend on the company’s current share price to indicate whether the stock is a good buy at the current level.

The ratio indicates how much working capital, cash, cash flow, and earnings an entrepreneur gets for each investment.

The following are some of the market ratios;

**Price to Earnings Ratio**

This ratio indicates the relationship between the price per share and total earnings per share. It is the exact amount the stock investor pays for single dollar earnings.

In accounting ratios, price to earnings is used to compare many companies to what others see in the market. Nearly all the companies use it as the start-off point for the valuation.

The advantage of the price to earnings ratio is that it is widely used, and this means any entrepreneur in the market can easily compare and contrast with other stocks and net income. One can also communicate with other investors easily as the majority of them have P/E in mind.

Its only biggest drawback is that it does not incorporate the balance sheet since Price to earning ratio never considers debt.

**Price to Cash Flow Ratio**

With accounting ratios, the price to cash flow ratio is used to measure the company’s ability to meet its day-to-day activities as far as generating cash relative to its market value is concerned.

This particular tool of financial ratios is the best alternative to P/E because cash flows are less prone to manipulation than earnings.

**Price to Sales**

This kind of financial ratio is used to compare companies with no positive net income—usually practiced by small businesses, a company in a financial crisis, or one with its assets’ current liabilities at their peak.

**What are Ratios Used for in Accounting?**

Accounting ratios play a crucial role in any business organization. The financial ratio analysis is used to forecast likely activities in the future. It indicates a company’s financial health since the past ratios indicate the trends in the cost of goods sold, gross profit, inventory turnover ratio, net sales, and debt ratio total liabilities.

Before injecting any cash into the business, investors always want to know the profitability ratios of the firm, the security and safety of their investment, and the growth potential of their investment. Financial experts use this accounting ratio to advise the investor.

Other places where financial ratios are applied include;

**Government**

The government may want to use the profitability ratios as a basis of taxation, subsidies, and grants.

**Management**

Management uses all types of ratios as it is interested in all business activities ranging from the financial position and the performance.

**Employees**

Concerned with their job security, employees will use profitability ratios and liquidity ratios to project the business’s continuity and bargain their wages and bonuses.

**Bankers and Lenders**

Banks and other financial lenders use profitability ratios and liquidity ratios to gauge the company’s ability to repay the borrowed loan plus the interest accrued. The banks may also look at the current liabilities before processing the loan.

**Suppliers**

They rely on liquidity ratios because their main interest is knowing the company’s ability to settle its short-term obligations and when. They also check the current assets that may be auctioned should the company fail to pay the debts.

**What is Profitability Ratio Formula?**

There are many types of profitability ratio formulas, and the one company uses on the level of the business and the preference of the management to track the performance. The following are some of them;

**Gross Profit Margin Ratio**

It is calculated by deducting direct expenses from the sales revenues. The expenses include the labor and the cost of raw materials incurred towards the production.

You finally get the margin by dividing the gross profit by the sales revenue. They are usually expressed in percentages.

**Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue*100%**

**Net Profit Margin Ratio**

Also known as profit after tax (PAT), the net profit is calculated by deducting all the sales revenue’s direct and expenses. Then, divide the net profit by sales revenues which is always expressed in percentage. The following is the simplified formula;

**Net Profit Margin = PAT / Revenue * 100%**

** EBITDA Margin Ratio**

It is calculated by adding all the taxes, depreciation amortization, and interest expenses to net profit. Then, divide EBITDA by sales revenue to the margin, which is always expressed in percentage.

**What is An Easy Way to Learn Ratios? **

There are plenty of summarised articles handling all types of ratios online and accounting e-books.

The other easy way of learning ratios is visiting youtube. There are many tutorial videos that can help any person who wants to venture into business. In the search bar, type anything related to the financial ratios, e,g current liabilities, current assets, and many more.

The other way is memorizing the formulas practicing day in day out. Just be flexible, learn how to place figures in the formulae, and you are good to go.

**How Do You Analyze Ratios in Accounting? **

Ratio analysis is the most useful way a business or a company can use to analyze its base as far as financial matters are concerned.

It is recommended to start from the simple process to the complex one as the business grows. For small businesses, experts recommend entrepreneurs use common size ratios to determine the business’s financial position.

Analyzing ratios is very simple like the common size ratio develops from both balance sheet and income statements.

Financial ratios are the best and most simple tools that every entrepreneur should adopt so as to know the financial position of their business and project for the future.

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