Accounting ratios assist in measuring the efficiency and profitability of a company based on its financial reports. Also called financial ratios, accounting ratios provide a way of expressing the relationship between one accounting datapoint and another, which is intended to provide a useful comparison. Accounting ratios form the basis of fundamental analysis.
Every year companies publish an annual report. The annual report contains three financial statements: the income statement, balance sheet and cash flow statement. Each statement provides the investor with information about the performance of the company over the most recent fiscal year. Analysts rely on the financial statements to provide the data needed to update accounting ratios.
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 for analysts to use when computing accounting ratios dealing with profitability. For example, gross profit as a percent of sales is an accounting ratio 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%. Both accounting ratios provide information about company profitability.
The balance sheet is a snapshot in time and provides accountants with data for calculating credit and debt ratios. The most popular debt ratio is debt-to-equity. 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 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%.