Accounting Ratios and Formulas: The Basics You Need to Know

A basic understanding of accounting is essential to running a small business. Keeping up with various accounting ratios and formulas, as well as bookkeeping processes, can be time-consuming, tedious work. But sticking with it can give you a clear picture of your company’s current financial health so you can make crucial decisions.

What are accounting ratios?

Accounting ratios measure your organization’s profitability and liquidity and can show if it’s experiencing financial problems. You can use them quarterly or annually, depending on your business type. They offer quick ways to evaluate your company’s financial condition and identify trends and other data to guide critical business decisions.

Understanding accounting ratios and formulas is worthwhile even if you choose accounting software to do much of the hard work for you. Essential ratios and formulas will differ according to your business’s needs. For example, a turnover ratio is crucial for brick-and-mortar retailers.

We’ll highlight commonly used accounting ratios to help you understand how they can benefit your business.

Liquidity ratios

Liquidity ratios calculate how capable your company is of paying its debts. They typically measure current business liabilities and liquid assets to determine your company’s likelihood of repaying short-term debts.

Common liquidity ratios include the following:

  • Current ratio = current assets ÷ current liabilities. This ratio measures if your company can currently pay off short-term debts by liquidating your assets.
  • Quick ratio = quick assets ÷ current liabilities. This ratio is similar to the current ratio above. However, to measure “quick” assets, you only consider your accounts receivable plus cash plus marketable securities.
  • Net working capital ratio = (current assets – current liabilities) ÷ total assets. The net working capital ratio calculates your assets’ liquidity. An increasing net working capital ratio indicates that your business is investing more in liquid assets than fixed assets.
  • Cash ratio = cash ÷ current liabilities. This ratio tells you how capable your business is of covering its debts using only cash. No other assets are considered in this ratio. For example, your accounts receivable and accounts payable aren’t considered because they represent future incoming client payments and future outgoing vendor payments.
  • Cash coverage ratio = (earnings before interest and taxes + depreciation) ÷ interest. The cash coverage ratio is similar to the cash ratio. However, it considers depreciation and calculates the likelihood of your business being able to pay interest on its debts.
  • Operating cash flow ratio = operating cash flow ÷ current liabilities. This ratio tells you how your current liabilities are covered by cash flow.

Profitability ratios

Accountants use profitability ratios to measure a company’s earnings versus business expenses. Common profitability ratios include the following:

  • Return on assets = net income ÷ average total assets. The return-on-assets ratio indicates how much profit companies make compared to their assets.
  • Return on equity = net income ÷ average stockholder equity. This ratio shows your business’s profitability from your stockholders’ investments.
  • Profit margin = net income sales. The profit margin is an easy way to determine how much of your income is from sales.
  • Earnings per share = net income ÷ number of common shares outstanding. The earnings-per-share ratio is similar to the return-on-equity ratio. However, this ratio indicates your profitability from the outstanding shares at the end of a given period.

Leverage ratios

A leverage ratio helps you see how much of your company’s capital comes from debt and how likely it is to meet its financial obligations. Leverage ratios are similar to liquidity ratios. However, leverage ratios consider your totals, while liquidity ratios focus on 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 shows you your assets available because of debt for longer than one year.

Turnover ratios

Turnover ratios measure your company’s income against its assets. There are many different types of turnover ratios, including the following:

  • Inventory turnover ratio = costs of goods sold ÷ average inventories. The inventory turnover rate shows how much inventory you’ve sold in a year or other specified period.
  • Assets turnover ratio = sales ÷ average total assets. This ratio is an indicator of how effectively your company is using assets to produce revenue.
  • Accounts receivable turnover ratio = sales ÷ average accounts receivable. You can use this ratio to evaluate how quickly your company can collect funds from its customers.
  • Accounts payable turnover ratio = total supplier purchases ÷ ((beginning accounts payable + ending accounts payable) ÷ 2). The accounts payable turnover ratio measures the speed at which a company pays its suppliers.

Market value ratios

Market value ratios deal entirely with stocks and shares. Many investors use these ratios to determine if your stocks are overpriced or underpriced. Common market value ratios include the following:

  • Price-to-earnings ratio = price per share ÷ earnings per share. Investors use the price-to-earnings ratio to see how much they’re paying for each dollar earned per stock.
  • Market-to-book ratio = market value per share ÷ book value per share. This ratio compares your company’s historic accounting value to the value set by the stock market.

Why look at financial ratios?

Accounting is the language of business: It tells a story. While these formulas may seem like arcane number-crunching, the results reveal your company’s health.

Running a successful business means learning from past mistakes and making healthy decisions for your future. Without a basic understanding of accounting, you can’t plan for your firm’s future.

Investigating and understanding your business’s financial health allows you to make accurate decisions about your future and set up your business for success. For example, the total debt ratio can be a key indicator of the right time to get a business loan. And the asset turnover ratio shows how valuable your assets are in relation to what you’re producing. This can prompt you to increase business efficiency or invest in new assets.

Financial accounting vs. cost accounting

There are various types of accounting. The accounting ratios and formulas we highlighted here involve figures from cost accounting, which determines how supply chain costs shape your actual manufacturing or service costs. This information is useful for external stakeholders but especially for internal ones, as the latter are in a position to make monetary changes.

Financial accounting is another accounting type. This approach focuses on your company’s financial standing rather than its ongoing costs. While financial accounting addresses the current financial health of your company, cost accounting assesses only costs associated with your business production.

If financial accounting is all about balance sheets and income statements, cost accounting is all about ratios and formulas. Realistically, you need both types of accounting — and that’s why most small businesses hire an accountant. Financial and cost accounting processes involve time-consuming work, so you’re better off delegating the responsibility to a third-party professional. This way, you can spend time on your most pressing tasks — the ones only you can do.

Doing the math: accounting ratios matter

Sure, your accounting software will automatically calculate and track all your ratios. But that’s only meaningful when you understand what these ratios signify for your business. Remembering ratios and formulas can feel overwhelming, but you don’t have to memorize them — just understand them. And whenever you need a refresher, come back to this guide. Keep it handy as you look at your accounting software to help you truly see your company’s complete financial picture.

Original Source: Business News Daily