What are accounting ratios?
Accounting ratios[i], also referred to as financial ratios, are used to evaluate, among other issues, the profitability, liquidity, efficiency, debt coverage, and market value of a business, such as a company, by comparing financial data of two line items in the financial statements.
The financial statements used as sources for the accounting ratios are the balance sheet, the income statement, and statement of cash flows.
Typically, financial ratios are calculated quarterly, bi-annually, or yearly. The importance of the various ratios differs from industry to industry.
Types of accounting ratios
Accounting ratios cover a variety of ratios that are used by financial analysts, accountants, management, and stakeholders such as shareholders and creditors.
Basically, accounting ratios can be classified into five types:
- Activity ratios
- Coverage ratios
- Liquidity ratios
- Market value ratios
- Profitability ratios
(Ratios are listed in alphabetical order and not necessarily in order of importance.)
Activity ratios
Activity ratios[ii], commonly referred to as efficiency ratios, determine how effectively a business uses its assets and liabilities to generate revenue and increase profits.
Activity ratios include the following ratios:
- Working capital turnover ratio
- Inventory turnover ratio
- Days of inventory ratio
- Cash conversion cycle
- Accounts receivable turnover ratio
- Average collection period ratio or average collection period in days
- Accounts payable turnover ratio
- Days of payables outstanding (DPO)
- Fixed asset turnover ratio
- Total assets turnover ratio
Working capital turnover ratio
Working capital (current assets minus current liabilities) refers to the capital that is used in the daily trading operations of a business.
- What the ratio measures
The working capital turnover ratio, also known as the working capital ratio, evaluates how efficiently a business utilises its working capital.
- Formulas to calculate the ratio
There are two formulas that can be used to calculate the working capital ratio of a business.
- Formula 1 – the standard formula
Working capital ratio = Current assets/Current liabilities
- Formula 2
Working capital ratio = Net sales/Working capital
Inventory turnover ratio
Inventory includes finished items ready for sale, items in the process of production, and items that will be used in the production process of items that can eventually be sold to customers.
- What the ratio determines
The inventory turnover ratio, also referred to as the merchandise inventory turnover ratio or the inventory utilisation ratio, calculates how often a business’s inventory balance is sold during a specific accounting period, for instance, six-months or a year. It determines how effectively a business manages its inventory.
- Formula
Inventory turnover ratio = Cost of sales/Average inventory
Where:
- Average inventory = (Opening inventory balance + Closing inventory balance)/2
Days of inventory ratio
- What the ratio calculates
The days of inventory ratio, also described as days of inventory on hand (DOH) or days in inventory, calculates how many days on average a business is storing inventory.
- Formulas
Different formulas can be used to calculate this ratio.
- Formula 1
Days of inventory ratio = (Average inventory/Cost of sales) x 365
- Formula 2
Days in inventory = (1/Inventory turnover ratio) x 365
- Formula 3
Days of inventory on hand (DOH) = Number of days in period/Inventory turnover ratio
Cash conversion cycle (CCC)
- What the cash conversion cycle indicates
The cash conversion cycle, also called the cash cycle, is an accounting tool, indicating how long it takes a business to convert its outlay on inventory into cash.
- Formula
Cash conversion cycle = DIO + DSO – DPO
Where:
- DIO = Days of inventory outstanding
- DSO = Days sales outstanding
- DPO = Days of payables outstanding
Accounts receivable turnover ratio
Accounts receivable, also referred to as receivables, are the amount of money owed to a business by its customers (debtors) for goods or services sold on credit accounts and that have already been delivered or used.
- What the ratio shows
The accounts receivable turnover ratio, also called the debtors’ ratio, shows how many times a business can turn its receivables into cash during a certain accounting period.
- Formula
Accounts receivable turnover ratio = Net credit sales/Average accounts receivable
Where:
- Net credit sales = Total sales – Cash sales.
- Average accounts receivable = (Accounts receivable opening balance + Accounts receivable closing balance)/2.
Average collection period ratio or average collection period in days
- What the ratio measures
The average collection period ratio, also referred to as the average collection period in days, measures how effectively a business can collect debt from debtors and what the average duration is to collect the money payable by debtors.
- Formulas
The ratio can be calculated by using one of the following two formulas:
- Formula 1
Average collection period ratio = Average accounts receivable/Average credit sales per day
- Formula 2
Average collection period in days = 365 days/Accounts receivable turnover
Accounts payable turnover ratio
Accounts payable, also known as payables, refer to money owed by a business to its creditors, for goods or services bought on credit.
- What the ratio indicates
The payables turnover ratio, also called the payables turnover ratio or the creditors’ turnover ratio, measures how quickly a business is paying off its creditors.
- Formula
Accounts payable turnover ratio = Total purchases/Average accounts payable
Where:
- Total purchases = Total purchases – Cash purchases
- Average accounts payable = (Accounts payable opening balance + Accounts payable closing balance)/2
Days of payables outstanding (DPO)
- What DPO shows
Another way to determine how efficient a company’s management of its creditors is, is to measure the number of days it takes to pay off creditors
- Formula
365 days/Accounts payable turnover ratio
Fixed asset turnover ratio
Fixed assets, also called non-current assets, are long-term tangible assets that are utilised by a business in its operations to generate long-term financial gain.
- What the ratio measures
The fixed asset turnover ratio measures a company’s ability to generate revenue from its investment in fixed assets.
- Formula
Fixed asset turnover ratio = Net sales/(Fixed assets – Accumulated depreciation)
Where:
- Net sales = Gross sales – (returns + discounts + allowances)
Total assets turnover ratio
Total assets are all the assets reported on a company’s balance sheet, such as fixed assets, current assets, intangible assets, and long-term investments.
- What the ratio indicates
The total assets turnover ratio measures how efficiently a business is managing and using its total assets to generate revenue during a certain accounting period.
- Formula
Total assets turnover ratio = Net sales/Average total assets
Where:
- Net sales = Gross sales – (discounts + allowances + returns)
- Average total assets = (Total assets opening balance + Total assets closing balance)/2
Coverage ratios
Coverage ratios[iii], also known as debt ratios or solvency ratios, are ratios used to determine a business’s ability to cover its debt obligations and to honour other associated costs, such as interest payments.
Coverage ratios comprise the following ratios:
- Debt ratio
- Debt-to-equity ratio
- Times interest earned ratio/Interest coverage ratio
- Debt-service coverage ratio
- Asset coverage ratio
Debt ratio
- What the ratio measures
The debt ratio, also called the debt to asset ratio or the total debt to total assets ratio, is used to measure the extent of a business’s leverage, indicating what percentage of a business’s assets are financed through debt, provided by creditors and lenders.
- Formula
Debt ratio = Total liabilities/Total assets
Debt-to-equity ratio
- What the ratio indicates
The debt-to-equity ratio compares a company’s total debt to its shareholders’ equity, expressing long-term debt as a percentage of owners’ equity.
- Formula
Debt-to-equity ratio = Total debt/Shareholders’ equity
Times interest earned ratio/Interest coverage ratio
- What the ratio implies
The times interest earned ratio, also referred to as the interest coverage ratio, is an indicator of a company’s ability to make interest payments on its debt.
- Formula
Interest coverage ratio = EBIT/Interest expense
Where:
EBIT = Earnings before interest and taxes
Debt-service coverage ratio (DSCR)
- What the ratio measures
The debt-service coverage ratio (DSCR) measures how well a business can cover all of its debt service. Put differently, the ratio compares cash flows to debt service payments such as capital and interest payments, payable in the short-term.
- Formula
DSCR = Net operating income/Total debt service charges
Asset coverage ratio
- What the ratio determines
The asset coverage ratio refers to a financial metric used in accounting to determine how effectively a business can pay back its debts by liquidating or selling its assets.
- Formula
Asset coverage ratio = (Total assets – Short-term liabilities)/Total debt
Liquidity ratios
Liquidity ratios[iv] are financial measurements used to evaluate the ability of a business to honour its short-term debt obligations, determining if a company is able to cover its current liabilities with its current assets.
Liquidity ratios cover the following types of ratios:
- Current ratio/Working capital ratio
- Quick ratio/Acid test ratio
- Cash ratio
Current ratio
- What the ratio indicates
The current ratio, also known as the working capital ratio, compares a business’s current assets with its current liabilities, indicating whether a business is able to pay off its current debt obligations with its current assets.
The ratio can also be classified under the activity ratios.
- Formula
Current ratio = Current Assets/Current liabilities
Quick ratio
- What the ratio indicates
The quick ratio, also referred to as the acid test ratio, is a financial indicator whether a business has enough current assets to be converted into cash (without selling any inventory) to honour its short-term debt obligations.
- Formula
Quick ratio = (Current assets – Inventory – Prepaid expenses)/Current liabilities
Cash ratio
- What the ratio measures
The cash ratio determines whether a company can meet its short-term debt obligations by only using its most liquid current assets, namely cash and cash equivalents.
- Formula
(Cash + Cash equivalents)/Current liabilities
Market value ratios
Market value ratios[v], enable analysts, investors, and stakeholders to evaluate the shares (stocks) of public traded companies, determining their financial condition.
Market value ratios include the following types of ratios:
- Price-to-earnings (P/E) ratio
- Earnings per share
- Book value per share (BVPS) ratio
- Market value per share
- Price-to-cash flow (P/CF) ratio
- Price-to-book (P/B) ratio/Market-to-book ratio
- Dividend yield ratio
Price-to-earnings (P/E) ratio
- What the ratio evaluates
The P/E ratio compares a company’s share price to its earnings per share. Express differently, it indicates how much investors are prepared to pay for the shares of a company per rand (ZAR) or US dollar of profits.
It is the most popular method to analyse a company’s shares.
- Formula
P/E ratio = Company’s current share price/ Earnings per share (EPS)
Earnings per share (EPS)
- What the calculation represents
Earnings per share (EPS) represents that portion of a company’s net income that is available to its ordinary shareholders. It is a metric used by investors to evaluate the performance of a company.
- Formula
Earnings per share = (Net income – Preference shares dividends)/Ordinary shares outstanding
Net income is also referred to as net earnings.
Preference shares are commonly known as preferred stock.
Ordinary shares (also called common stock) outstanding, as reported at the end of a specific reporting period and expressed as the weighted average number of shares outstanding.
Book value per share (BVPS) ratio
- What the ratio indicates
Book value per share (BVPS), also called book value of equity per share, refers to the book value of a company on a per-ordinary share basis, representing the minimum value of a company’s equity available to ordinary shareholders.
Put differently, BVPS indicates a company’s net asset value (total assets – total liabilities) on a per-ordinary share basis.
The ratio enables analysts and investors to determine whether a company’s share price is undervalued.
- Formula
BVPS = (Total shareholders’ equity – Preference shareholders’ equity)/Total shares outstanding
Market value per share
The market value per share, also commonly known as the fair market value of a share or stock of a company, reflects the current value that traders and investors are willing to pay for an ordinary share of the company.
Price-to-cash-flow (P/CF) ratio
- What the ratio tells you
The price-to-cash flow (P/CF) ratio, also called price/cash flow ratio, is a financial indicator that measures the value of a company’s share price in relation to its operating cash flow per share. In other words, the ratio determines how much cash a company generates relative to its share price.
- Formulas
Two formulas can be used to calculate the P/CF ratio:
- Formula 1
Price-to-cash flow ratio = Market capitalisation/Operating cash flow
Where market capitalisation = Share price x number of outstanding shares.
- Formula 2
Price-to-cash flow ratio = Share price/ Operating cash flow
Price-to-book (P/B) ratio
- What the ratio does
The price-to-book (P/B) ratio, also known as the market-to-book ratio, compares a company’s market capitalisation to its book value (= the carrying value on the balance sheet). Put differently, the ratio indicates the value the market currently places on a company’s shares, as reflected by the share price, relative to the company’s book value.
- Formulas
The P/B ratio can be calculated in two ways:
- Formula 1
Price-to-book ratio = Market price per share/Book value per share (BVPS)
- Formula 2
Price-to-book ratio = Market price per share/(Assets – Liabilities)
Dividend yield ratio
- What does the ratio show?
The dividend yield is a financial ratio that indicates how much a company pays out in dividends in each financial year relative to the market value per share. Put in other words, the dividend yield ratio calculates what percentage of the market price of a company’s share is annually paid to shareholders by way of dividends.
- Formula
Dividend yield = Dividend per share/Market value per share
Where:
- Dividend per share is the total of the dividends annually paid by the company, divided by the total number of shares outstanding.
- Market value per share refers to the company’s current share price.
Profitability ratios
Profitability ratios[vi] are a group of ratios that determine how able and efficient a company is to generate profit and value for its shareholders relative to its income, operating costs, assets, or shareholders’ equity.
Profitability ratios comprise the following types of ratios:
- Gross profit ratio
- Net profit ratio/Net profit margin
- Return on total assets (ROA) ratio
- Return on equity (ROE) ratio
- Basic earning power (BEP) ratio
- Contribution margin ratio
Gross profit ratio
- What the ratio measures
The gross profit ratio measures the percentage of profits generated by the sale of goods or services, prior to the effect of expenses such as administrative, marketing, and selling expenses.
Gross profit as a percentage of sales is called gross margin.
- Formula
Gross profit ratio = Gross profit/Sales
Where:
- Gross profit is the difference between revenue and cost of goods sold (COGS).
Net profit (NP) ratio
- What the ratio indicates
The net profit (NP) ratio shows the relationship between net profit after tax and net sales (revenue), evaluating the profitability of a business from its primary operations.
The net profit ratio, also called the profit margin, net profit margin, or net profit margin ratio, measures the amount of net profit a business generates per rand (ZAR) or dollar of revenue gained.
- Formula
Net profit ratio = (Net profit after tax/Total revenue) x 100
The ratio is expressed as a percentage.
Net profit is also known as net income.
Return on total assets (ROA) ratio
- What the ratio reflects
The return on total assets (ROA), also called return on assets, is an indicator of how profitable a business is relative to its total assets, reflecting how effectively a business manages its assets to generate net income.
- Formula
Return on total assets = Net income/Total assets
The ratio is displayed as a percentage.
Return on equity (ROE) ratio
- What the ratio shows
The return on equity (ROE) ratio compares net income (profit) to shareholders’ equity, showing how much money shareholders receive for their investment in a company.
- Formula
Return on equity ratio = Annual net income/Shareholders’ equity
The ratio is expressed as a percentage.
Basic earning power (BEP) ratio
- What the ratio indicates
As with the return on assets (ROA) ratio, the BEP ratio also indicates how efficiently a company manages its assets to generate income. However, the BEP ratio measures the operating earning power of the assets, contrary to the ROA ratio, which measures the net earning power of a company’s assets.
- Formula
Basic earning power ratio = EBIT/Total assets
Where:
- EBIT = Earnings before interest and taxes. Hence, excluding the influence of taxes and finance charges.
Contribution margin ratio
- What the ratio measures
The contribution margin ratio is the difference between a business’s sales and variable expenses, expressed as a percentage. The ratio measures the amount of money available to cover all the fixed expenses of the business.
- Formula
Contribution margin ratio = (Sales – Variable expenses)/Sales
Advantages of accounting ratios
- Accounting ratios are useful in setting goals for acceptable and improved performances for a business.
- Helpful to compare businesses on an industry basis, allowing management to recognise how the firm performs compared to competitors in the same industry.
- Enable a firm to evaluate its performances across periods of time such as a quarter or financial year.
Disadvantages of accounting ratios
- Inflation can distort financial data from one reporting period to another, causing the ratios to be irrelevant.
- Seasonal and cyclical sales could provide distorted financial results because sales vary considerably between time periods.
Financial ratios are not useful for multi-divisional companies as a whole, restricting the use of ratios only to the divisions of
[i] Refer to the articles below for a detailed explanation of the various types of accounting ratios.
[ii] ‘Activity Ratios in Accounting Explained for Dummies’
[iii] ‘Coverage Ratios in Accounting Explained for Dummies’
[iv] ‘Liquidity Ratios in Accounting Explained for Dummies’
[v] ‘Market Value Ratios in Accounting Explained for Dummies’
[vi] ‘Profitability Ratios in Accounting Explained for Dummies’
Top 4 Brokers
