What is an Accounting Ratio
Accounting ratios, also known as financial ratios, are used to measure the efficiency and profitability of a company based on its financial reports. They provide a way of expressing the relationship between one accounting data point to another, and are the basis of ratio analysis.
BREAKING DOWN Accounting Ratio
An accounting ratio compares two line items in a company’s financial statements, namely made up of its income statement, balance sheet and cash flow statement. These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year. Examples of financial ratios include gross margin, operating margin, the debt-to-equity ratio, the quick ratio and the payout ratio. Each of these ratios requires the most recent data in order to be relevant. For more on how to use financial ratios, read Ratio Analysis: Using Financial Ratios.
Gross Margin and Operating Margin
The income statement contains information about company sales, expenses and net income. It also provides an overview of earnings per share and the number of shares outstanding used to calculate it. These are some of the most popular data points analysts use asses a company’s profitability. For example, gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. Operating profit as a percentage of sales is referred to as operating profit margin. It is calculated by dividing operating profit by sales. For example, if operating profit is $60,000 and sales are $100,000, the operating profit margin is 60%.
The balance sheet provides accountants with a snapshot of a company’s capital structure, one of the most important measures of which is the debt-to-equity ratio. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1.
The Quick Ratio
The quick ratio, also known as the acid-test ratio, is an indicator of a company’s short-term liquidity, and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we're only concerned with the most liquid assets, the ratio excludes inventories from current assets. Quick ratio is calculated as follows: Quick ratio = (current assets – inventories) / current liabilities
The cash flow statement provides data for ratios dealing with cash. For example, the payout ratio is the percentage of net income paid out to investors. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement. For example, if dividends are $100,000, share repurchases are $100,000, and income is $400,000, the payout ratio is calculated by dividing $200,000 by $400,000, which is 50%.