Accounting Ratios And What They Mean
Accounting ratios are vital to business. Why? because they can give you a fast insight into how a business is performing financially.
And right at the top of the accounting ratio tree is The Accounting Equation, so that’s where we will start.
The Accounting Equation
Assets = Liabilities + Equity: This is the basis on which everything else is built. If the assets of a business do not add up to the liabilities plus equity, it is likely everything else will also be wrong.
Assets represent everything the business or entity owns. That could be buildings, vehicles, offices, equipment, fixtures and fittings and anything else that the business has bought that will be used in the running of the business.
This also includes monetary accounts such as your bank (because if you have money in the bank, it is classed as an asset of the business). In fact, any account that contains money is an asset including cash and savings.
Some assets are long term (which means they last longer than a year – or they cannot be converted to cash quickly), others are short term – also called ‘Current Assets’ – that’s where your bank and cash accounts fit in.
When you look at the balance of your assets, you get the ‘bricks and mortar’ value of the business. But without also looking at the liabilities, you have no idea how much of that ‘bricks and mortar’ value is the businesses to keep (which is displayed in the equity section covered shortly).
Liabilities are everything the business or entity owes to third parties. Liabilities include loans the business has taken out. These can be short term (a quick cash loan to get you over a lean cashflow period) or a long term loan to buy an asset for example. Liabilities also include any money the business owes its suppliers.
Knowing what a business owes and how long it has to repay those liabilities is vital for cash flow. If a business has no idea when loans will become due to be repaid, it can find itself so short of cash, it may be forced into liquidation.
Equity is everything the business owes to its owners. To get this, add up all the assets and subtract the liabilities. The balance represents the owners capital in the business. That is, how much the owner is owed by the business should the business be sold at that point in time.
Example: If the owner of a business puts in capital of 100, then Assets will equal 100 and Equity will equal 100 and the equation balances 100 = 0 + 100. If the business then borrows 25 as a loan, Liabilities will increase from 0 to 25 and Assets will also increase by 25, so the equation becomes 125 = 25 + 100: (Assets = 100 capital + 25 loan injection of cash) = (Liabilities of 25 from the loan) + (original injection of Capital of 100).
If the total assets do not equal total liabilities plus total equity, it tells us there is an error somewhere in the accounts.
As long as the accounting equation balances, then all other equations and ratios can be explored. And top of everything is the Acid Test.
Acid Test Ratio (aka Quick Asset Ratio): The acid test is a quick financial health check. However, be warned that it doesn’t help reveal if anything bad is pending or about to happen to a business.
Here’s the equation: (Current assets less inventory and pre-paid expenses) divided by current liabilities. Add up the total current assets (bank + cash etc.), then subtract the total value of the businesses stock or inventory (ie. unsold goods and raw materials used in the manufacture of goods). Also deduct any items that have been paid in advance. Finally divide that total by current liabilities (eg. items due to be repaid within a year).
Gearing or Borrowing Ratio: Borrowings (all loans) divided by equity. For example, if the equity is 100 and the total loans are 30, the borrowing ratio expressed as a percentage is 30% (a business can also be said to be 30% geared using this example).
Current Ratio (aka Working Capital Ratio): Current assets divided by current liabilities. This tests how much working capital the business has (its assets) against what it owes (its liabilities).
If current assets were 100 and current liabilities were 150, then the ratio expressed as a percentage would be 150%, and it would be clear the business would be in trouble if all the creditors were to call in their loans early, and all the debtors refused to pay up.
Creditors’ Payment Period (aka Payable’s Turnover): Creditors (aka Accounts Payable) divided by purchases on credit multiplied by 365 (the result gives an average period in days of how long it takes to make payment)
Debtors’ Collection Period (aka Receivables Turnover): Debtors (aka Accounts Receivable) divided by sales on credit multiplied by 365 (the result gives an average period in days of how long it takes to receive payment)
Fixed Asset Turnover Ratio: (Sales less direct costs) divided by fixed assets
Inventory Ratio: Cost of goods sold (COGS) divided by average stock on hand. The figures are taken for a particular period of time, and the result gives an indication of how many times the inventory was turned over during that period.
Rate of Stock Turnover: Cost of sales (COS) divided by average stock held during the year
Total Asset Turnover Ratio: (Sales less direct costs) divided by total assets
Capital Gearing Ratio: (Preference share capital plus debentures plus long term loans) divided by (equity share capital plus reserves) multiplied by 100
Dividend Cover: Profits available for dividends divided by dividends
Dividend Yield: Ordinary dividend divided by market price of ordinary share multiplied by 100
Earnings per Share (EPS): Net profit less preference dividend divided by number of issued ordinary shares
Equity (or Proprietor’s) Ratio: Proprietor’s capital divided by assets
Interest Cover: Profits reserved for interest payments divided by interest
Price/Earnings Ratio (P/E): Market price of ordinary share divided by earnings per share (EPS)
Debt Assets Ratio: Liabilities divided by assets
Debt Equity Ratio: Liabilities divided by equity
Gross Profit: Sales less Cost of Sales. If you sold something for 100 that cost 25 to buy, then the gross profit would be 75.
Gross Profit Margin: (Sales less direct costs) divided by sales multiplied by 100
Gross Profit Margin Ratio: Gross profit divided by sales
Net Profit: Sales less all costs including expenses and overheads
Net Profit Margin: Net profit before tax divided by sales
Net Profit Ratio: Net profit margin multiplied by 100
Operating Profit Ratio: (Profit divided by (sales less sales related costs and expenses)) multiplied by 100
Return on Assets (ROA): Net income divided by fixed assets
Return on Capital Employed (ROCE): Net profit before interest and taxation (EBIT) divided by capital employed at the start of the year (ie. assets less debtors)
Return on Owners Equity (ROOE): Net profit before interest, tax and preference share dividends divided by owners equity at the start of the year (ordinary issued share capital plus all reserves)
Return on Investment (ROI): Net profit divided by capital employed
Return on Net Assets (RONA): Net income divided by (fixed assets plus net working capital). This is a measure of a company’s performance. The higher the value, the better the performance.Join The Accounting for Everyone Online Bookkeeping Course