Accounting Ratios: Definitions and Different Types

What Are Accounting Ratios?

Accounting ratios are quantitative tools derived from a company’s financial statements. They evaluate how efficiently a business is operating, how profitable it is, whether it can meet its short-term and long-term obligations, and how it is valued by the market. These ratios involve relationships between different financial variables such as revenue, expenses, assets, liabilities, and equity. By comparing elements from the income statement, balance sheet, and cash flow statement, accounting ratios offer concise and meaningful insights.

For example, comparing net income to shareholder equity helps evaluate how effectively the company is using owners’ capital to generate profits. Similarly, examining current assets against current liabilities reveals whether the company can meet its short-term obligations.

Accounting ratios also enable stakeholders to compare a company’s performance across time periods and against industry standards. This comparability makes them a cornerstone of financial analysis.

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Types of Accounting Ratios

Accounting ratios can be broadly classified into five key categories. Each type offers a different perspective on a company’s financial health:

Liquidity Ratios

These ratios assess a firm’s ability to meet its short-term obligations with its current assets. They are crucial for evaluating the firm’s cash flow position.

Current Ratio = Current Assets / Current Liabilities
A ratio above 1 is considered healthy, showing that the company has more assets than liabilities due within a year.
Example: If a company has ₹300,000 in current assets and ₹200,000 in current liabilities, the current ratio is 1.5.

Quick Ratio = (Current Assets – Inventory) / Current Liabilities
A more stringent test than the current ratio, as inventory may not be quickly convertible into cash.

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Profitability Ratios

These ratios indicate how well a company converts revenue into profit and returns to shareholders.

Net Profit Margin = Net Profit / Revenue
Measures how much of each rupee of revenue results in profit.
Example: A 15% net profit margin means ₹0.15 of every ₹1 earned is net income.

Return on Equity (ROE) = Net Income / Shareholder’s Equity
Reflects how efficiently shareholders’ capital is being used.

Solvency Ratios

Solvency ratios evaluate a firm’s long-term financial stability and ability to meet debt obligations:

Debt-to-Equity Ratio = Total Debt / Shareholder’s Equity
A high ratio suggests reliance on borrowed funds, increasing financial risk.

Interest Coverage Ratio = EBIT / Interest Expense
Measures how easily a company can pay interest from its operating earnings.
Example: A ratio of 3 means the company earns three times its interest obligations.

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Efficiency Ratios

These ratios assess how well a company utilizes its resources to generate income:

Asset Turnover Ratio = Net Sales / Average Total Assets
Higher ratios indicate efficient use of assets.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Measures how many times inventory is sold during a period. A higher ratio indicates effective inventory management.

Market Ratios

Market ratios provide insight into a company’s valuation from the perspective of investors:

Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (EPS)
Reflects market expectations; a high P/E may indicate growth expectations or overvaluation.

Earnings per Share (EPS) = Net Income / Number of Outstanding Shares
Indicates the profitability attributed to each share of stock.

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