Ratio Analysis in Accounting

Once the company’s financial statements are prepared, Ratio analysis tool is used to analyze the financial position of the company. It is the quantitative method of examining the company’s profitability, operational efficiency, and liquidity with the help of comparing financial statement’s line-items. Ratio analysis is widely used by the analysts and investors to evaluate the investment opportunities within the organization by scrutinizing current and past financial statements. The analysis helps to compare the company’s financial health with other competitive companies by assuming industry benchmarks. In addition to this, ratio analysis helps to analyze the downward and upward trend of the organization.

Furthermore, in order to examine the company’s financial performance in the market with respect to the similar companies, ratio analysis provides a detailed comparison. With the help of this comparison, management could identify the market gap, opportunities, weaknesses and company’s competitive advantage over other companies. Thus, this helps to formulate decision on the basis of solid reasoning to improve the company’s efficiency. The efficiency of the management of liabilities and assets could also be examined by using financial ratios. It also determines the effectiveness of the financial resources: under or over-utilized.

Ratio Analysis in Accounting

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Types of Ratio Analysis

Ratios are categorized as follows:

  1. Liquidity Ratios
  2. Activity Ratios
  3. Profitability Ratios
  4. Leverage Ratios

Ratio

Formula

Explanation

Liquidity Ratios

Liquidity ratios indicate company’s liquidity position and its ability to pay off its Short-term obligations.

Current Ratio

Current Assets / Current Liabilities

Current Assets = Cash + Short-term Marketable securities + Account Receivable + Prepaid Expenses + Inventory

Quick Ratio

Quick Assets / Current Liabilities

Quick Assets = Cash + Short-term Marketable securities + Account Receivable

Super Quick Ratio

Cash + Short-term Marketable securities / Current Liabilities

Super Quick Assets = Cash + Short-term Marketable securities

Activity Ratios

Activity ratios indicate efficiency of how quickly company convert its assets into cash.

Accounts Receivable Turnover Ratio

Net Credit Sales / Average Account Receivables

Average Account Receivables = (Opening  A/Receivable + Ending A/Receivable) / 2

Merchandise Inventory Turnover Ratio

Cost of Goods Sold / Average Inventory

Average Inventory = (Opening  Inventory + Ending Inventory) / 2

Total Assets Turnover Ratio

Cost of Goods Sold / Average Total Assets

Average Assets = (Opening Assets + Ending Assets) / 2

Profitability Ratios

Profitability ratios indicate company’s ability to create profit relative to its revenues.

Gross Profit Ratio

Gross Profit / Total Net Sales

Net Sales = Total Sales – (Sales Return + Sales discount)

Operating Ratio

(COGS + Operating Expenses) / Total Net Sales

COGS = Cost Of Goods Sold

Return on Total Assets (ROA)

Earning After Tax & Interest / Average Total Assets

Average Assets = (Opening Assets + Ending Assets) / 2

Return on Investment (ROI)

Net Income / Capital Employed

Capital Employed = Equity + Long Term Liabilities

Earning Per Share (EPS)

Net Income / Number of Shares

 

Book Value per Share

Ordinary Share Equity / Number of Shares

 

Leverage Ratios

Leverage ratios indicate company’s ability to pay off its Long-term obligations.

Debt Equity Ratio

Total Debt / Shareholder Equity

Total Debt = Short Term Debt + Long Term Debt

Debt to Total Assets

Total Debt / Total Assets

Total Debt = Short Term Debt + Long Term Debt

Interest Coverage Ratios

EBIT / Interest

EBIT = Earnings Before Interest & Tax

Calculation

A detailed step by step calculation of the given three ratios including current ratio, trade payable days and trade receivable days has been calculated with the help of assumed numerical data. The analysis will provide an insight about how financial ratios are calculated.

Current Ratio

            The current ratio determines the working capital of the company and indicate the company’s ability to pay its debts from its available current assets. Thus, the numerical data for this ratio would include total current assets and total current liabilities. ABC holds Cash $10 million, Marketable securities $10 million, Short-term debt $25 million, Inventory $35 million and the Accounts payables of $15 million.

Ratio Formula

Current Ratio = Current Assets / Current Liabilities

Calculation

Total Current Assets = Cash+ Marketable securities+ Inventory

                                  = 10 million+ 10 million +35 million = $55 million

Total Current Liabilities = Short-term debt+ Accounts payables

                                        = 25 million+ 15 million = $40 million

Current Ratio = $55 million/ $40 million = $1.375

Here, company have enough current assets to pay off its liability.

Trade Payable Days

            Trade payable ratio is an efficiency ratio which helps to analyze the company’s average time taken to pay its debts to its creditors. Trade payable days identify the average time period for paying the invoices and outstanding debts. It is recommended that companies should strive to increase its Trade payable days to maximize its cash conversion cycle.

ABC Company made its purchases on the basis of credit purchase. At the end of the fiscal year, ABC Company holds $150,000 as its total credit purchases with the account payable of $10,000 for the current year and $5,000 for the previous year.

Ratio Formula

Accounts payable turnover ratio = Total purchases / Average accounts payable

Trade Payable Days = 365 /Accounts payable turnover ratio

Calculation

Accounts payable turnover ratio = 150,000/ (($10,000+ $5,000)/2) = 30

Trade payable days = 365 /13.33 = 12.16 or 12 days

Trade Receivable Days

            Trade receivable ratio is an efficiency ratio which helps to analyze the company’s ability to collect its revenues and determine how efficiently company is utilizing its assets. Trade Receivable days indicates the ability of the company to collect its credit sales from its customers. It is recommended that companies should strive to minimize its Trade Receivable days to maximize its cash conversion cycle.

ABC Company made its sales on the basis of credit sale. At the end of the fiscal year, ABC Company holds $200,000 as its total credit sales with the account receivable of $20,000 for the current year and $10,000 for the previous year.

Ratio Formula

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Trade Receivable days = 365 / Receivable turnover ratio

Calculation

Accounts Receivable Turnover Ratio = $200,000/ (($20,000+ $10,000)/2) = 13.33

Trade Receivable days = 365 /13.33 = 27.37 or 27 days.

Advantages of Ratio Analysis

Ratios analysis provides a valuable insight to examine the company’s financial performance. The advantages of ratio analysis have been discussed in detail below:

  • With the help of ratio analysis, the management could evaluate and compare the financial situation of the company and then will become able to disapprove or validate the operating, investment and financing decisions of company.
  • With the help of ratios, the manager can covert the complex financial data and financial statement into a simple and identifiable ratio to examine the company’s long-term, solvency, financial efficiency, and operating efficiency.
  • With the help of large number of financial reporting data, organizations can obtain the financial performance trend which helps to predict future financial performance and to identify the expected financial turbulence. In addition to this, it pinpoints the problem areas.
  • With the help of ratio analysis, organizations can conduct comparison analysis with other competitive organizations to examine fiscal position and market gap in the industry.

Limitations of Ratio Analysis

The limitation of the ratio analysis may include:

  • Ratio analysis determines only the quantitative aspects of the organization, while completely ignore the qualitative perspective of the company.
  • Due to inflation, there are price level changes. Ratio analysis is based on the historical data analysis which ignore overlooked the price level changes within the given time period.
  • Accounting ratios are unable to resolve any financial problem. Thus, fails to provide actual solution for the identified financial gap.
  • The comparison between two companies with different diversified product portfolio, different age and size is unable to provide effective comparison. It would be difficult to interpret the result of two substantially different organization under the same box. In addition to this, it is challenging and difficult to identify an effective and adequate industry benchmark comparison standard to compare the company’s ratios.

Key Points

  • Ratio analysis tool is used to analyze the financial position of the company
  • It is broadly categorized into four main types; Liquidity Ratios, Activity Ratios, Profitability Ratios, & Leverage Ratios.
  • Organizations can conduct comparative ratio analysis with other competitive organizations to examine market gap in the industry.
  • It tells only the quantitative aspects of the organization, and ignore the qualitative perspective of the company.

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Hira Aziz

Hira Aziz - Author

She is a Business Content writer and Management contributor at 12Manage.com, where she contributes a business article weekly. She has over 2 years of experience in writing about accounting, finance, and business.

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