What are Accounting Ratios?
Accounting ratios are used by businesses to measure profitability and efficiency. There are lots of different ratios. In the article, we will look at some of the most common ones and also provide calculators and examples.
The financial statements of a business include lots of figures and may not make much sense. By using ratios and comparing figures, the numbers can become much more transparent. The financial statements include the profit & Loss and Balance sheet.
Using the figures will allow you to compare the business performance from one period to another. It is useful in comparing years, quarters or months.
Students need to learn ratios as part of their studies and exams.
What are Profitability Ratios?
We are going to start by looking at profitability ratios. The profitability of a business is reported in the Profit and Loss or Income Statement. It is an easy way to see how a business is performing and compare it to other periods.
The profit and loss account is split into several sections, which includes revenue (sales), the direct cost of sales, gross profit, expenses and net profit. The figures from the below example Profit and Loss account are used to calculate profit ratios using the following formulas:
Gross Profit Ratio
The gross profit ratio or margin ratio measures the revenue and the gross profit and is given as a percentage. Gross profit is revenue, less costs related directly to the production of goods. Direct costs can include materials, labour and anything else that is calculated as a direct cost of producing the product or service.
As with all accounting ratios, you can use the above calculation to compare it with a different period.
Net Profit Margin
The Net profit margin ratio measures the net profit from the profit and loss account against revenue. The Net profit is calculated by taking the gross profit and deducting the expenses. Expenses include other running costs of the business, which do not relate directly to sales. It includes items like advertising, utilities, post, rent and wages.
As you can see from the examples of accounting ratios above, the gross profit margin is much higher than the net profit margin.
Net and Gross profit Margin Calculator
Use our profitability ratio calculator below for your own figures. By entering different period figures into the calculator it is easy to compare two periods.
Gross Profit Markup Ratio
The gross profit markup ratio looks at the gross profit compared to the cost of producing the product. The ratio can be used for both an individual product (if you have the figures) or from the Profit and Loss Account.
A useful formula for a business is to know its break-even point. It is the point where a businesses sales equal both the fixed and variable costs. Our guide also includes an Excel template and an example.
What is the Current Ratio?
The current ratio is a liquidity ratio and measures if a business can pay its debts. The figures are from the balance sheet and include the current assets and current liabilities.
Current liabilities is money you owe to others and are due within a year. Current liabilities include accounts payable, wages and taxes payable, accrued expenses and overdrafts.
Below is the formula showing how to calculate the current ratio:
An example of a current ratio is a business that has current assets of 6000 and current liabilities of 1500. It is measured in numbers, the closer to 1 the less able a business is to pay its debts.
Acid Test Ratio
The acid test ratio goes further than the current ratio, it is also known as the quick ratio. It is used by investors to measure how its short term assets can cover its liabilities or debts. The acid test excludes stock and prepayments. It looks at the immediate cash available to cover the liabilities. The reason for using this ratio is that some businesses have stock that can’t be sold or it takes a long time to sell.
Using the same figures as the current ratio, but also including a figure for stock of 1000, the equation looks like this:
Another accounting ratio is a gearing ratio. The gearing ratio measures the companies financial leverage or the amount of business funding that comes from borrowing. The ratio is mainly used by lenders or investors.
Further accounting ratios are available on the Investopidia website.
Return from accounting ratios to balance sheet page.