Businesses prepare financial statements that provide useful information to the user of those statements. Financial statements prepared by businesses consist of the Statement of Financial Position, Statement of Profit or Loss, Statement of Cash Flows and Statement of Owners’ Equity along with the Notes to the Financial Statements. Each financial statement has its uses and can provide unique information regarding the business based on which its stakeholders can make decisions. For example, the Statement of Financial Position shows the total assets, equity and liabilities of a business, while the Statement of Profit or Loss gives an overview of the performance of the business.
There are many ways that users or stakeholders can interpret the information provided in these financial statements. For example, they can compare the information provided in the financial statements with historical information of the business to evaluate changes over time. Similarly, they can compare the information in the statements with other similar businesses to identify differences with other businesses. Users can also use ratios or percentages for obtaining more useful information that they cannot get by comparing values of financial statement items with historical figures.
Definition of Accounting Ratio Analysis
Accounting ratio analysis is the process of using different ratios to obtain insights into the liquidity, profitability, operation efficiency and profitability of a business. The information required to calculate these ratios is readily available, thus, making calculation straightforward. Users of financial statements can use ratio analysis to evaluate the performance of a business over time. Furthermore, they can also use calculated ratios as a comparison tool with historical information for even better insight into the performance of a business.
Types of Ratio Analysis with Example and Explanation
There are many types of ratio analysis categorized based on what they measure. These types of ratio analysis include profitability, liquidity and gearing ratios.
Profitability ratios measure the financial performance of a business or its ability to generate profits. Profits are the main indicator of the performance of a business over a certain period. Therefore, most financial statement users use them frequently. The main profitability ratios include the Gross Profit Margin, Net Profit Margin and Return On Capital Employed (ROCE).
Gross Profit Margin
The Gross Profit Margin focuses on the trading activities of a business. It is the ratio of the gross profit of a business to its total sales presented in the form of a percentage. The Gross Profit Margin of a business can help users understand how much of the revenues of a business convert into profits. It can also give insights regarding the production costs of a business to a user. A higher Gross Profit Margin is always better. The Gross Profit Margin formula is as below:
Gross Profit Margin = Gross Profit / Sales x 100
For example, a business having a gross profit of $10,000 and sales of $25,000 will have a Gross Profit Margin of 40% ($10,000 / $25,000).
Net Profit Margin
Net Profit Margin is very similar to the Gross Profit Margin. However, instead of considering the gross profit of a business, it considers its net profits. The Net Profit Margin can give useful insights into the ability of a business to convert its sales into net profit. Users of the financial statements prefer high Net Profit Margins. The Net Profit Margin formula is as below:
Net Profit Margin = Net Profit / Sales x 100
For example, a business having a net profit of $5,000 and sales of $25,000 will have a Gross Profit Margin of 20% ($5,000 / $25,000).
Return On Capital Employed
Return On Capital Employed (ROCE) is a profitability ratio that is different from the above two ratios. The ROCE of business shows users its ability to use the resources at its disposal to generate profits. The higher the ROCE of business is, the more investing in it will be attractive to investors. The ROCE formula uses capital employed, which consists of the non-current liabilities and total equity of a business. The ROCE formula is:
ROCE = Earnings Before Interest and Tax / Capital Employed (Non-current liabilities + Total equity)
A business with earnings before interest and tax of $5,000 and capital employed of $40,000, will have a ROCE of 12.5% ($5,000 / $40,000).
These ratios measure the ability of an entity to meet its short-term financial obligations. The liquidity of a business is its ability to convert its assets into cash, which is a crucial asset for a business. There are two main liquidity ratios that users can benefit from, namely the Current ratio and the Acid Test ratio (also known as Quick ratio).
Current Ratio is the ratio of the current assets of a business to its current liabilities. The ratio helps users determine whether the business has enough current assets to meet its current liabilities. Typically, a current ratio of 2:1 is preferable. However, for some industries, even a ratio below 2:1 may be acceptable. The current ratio formula is as below:
Current Ratio = Current Assets / Current Liabilities
For example, a business having current assets worth $100,000 and current liabilities totaling $80,000 will have a Current Ratio of 1.25:1 or, simply, 1.25 ($100,000 / $80,000).
Acid Test Ratio
The Acid Test Ratio is very similar to the Current Ratio, but when comparing the current assets of a business to its current liabilities, it does not consider inventory. This is mainly because inventory is a less liquid asset as compared to other current assets of a business. Usually, an Acid Test Ratio of 1:1 or above is preferable to users. The formula to calculate Acid Test Ratio is:
Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities
For example, a business having current assets worth $100,000, inventory worth $20,000 and current liabilities totaling $80,000 will have an Acid Test Ratio of 1:1 ((100,000 – $20,000) / $80,000).
While liquidity ratios relate to the ability of a business to meet its short-term obligations, gearing ratios relate to its ability to meet its long-term obligations. There are two commonly used gearing ratios, namely the capital gearing and interest cover.
Capital gearing, also known as leverage, is a ratio that compares the total long-term debt of a business and its owners’ equity. Users use it to find the proportion of the owners’ capital and debt used to finance a business. Usually, a lower capital gearing ratio is better as it means the business relies on owners’ capital rather than debt to finance activities. The formula to calculate capital gearing is:
Capital Gearing = Non-current Liabilities / Owners’ Capital
For example, a business having non-current liabilities of $100,000 and owners’ capital of $125,000 will have a capital gearing of 0.8.
Interest cover, also known as income gearing, is a calculation of how many times does the earnings before interest and tax profit of business cover its interest payable. The higher the interest cover ratio of business is, the better it will be able to pay off its interests from its profits. Interest cover is a ratio commonly used by financial institutions. Below is the formula to calculate the interest cover:
Interest Cover = Earnings Before Interest and Tax / Interest Expense
For example, a business having earnings before interest and tax of $20,000 and interest expense of $5,000 will have an interest cover of 4 ($20,000 / $5,000).
Why Ratio Analysis is Important?
Accounting ratio analysis is important for several reasons. The first reason is that ratio analysis helps both a business and its stakeholders analyze its financial statements. Second, it can help them understand the profitability, liquidity, gearing and other aspects of the business even better. Accounting ratio analysis can also help provide an analysis of the efficiency of businesses and their operations. Furthermore, ratio analysis can also be used as a comparison tool by users who want to compare the performance of a business with other businesses. Sometimes, ratio analysis can also be helpful to the management of the business in planning and forecasting its activities.
Limitation of Ratio Analysis
Accounting ratio analysis can also have some limitations. First of all, while ratio analysis can provide helpful information, it still uses historical information from the financial statements of a business. Secondly, by relying on financial statements, ratio analysis will not give any information that isn’t already provided in the financial statements, only enhance the quality of it. Likewise, since it depends on financial statements, ratio analysis is also prone to manipulation. Furthermore, accounting ratio analysis cannot be used as a comparison tool when there are changes in the accounting policies of a business. Similarly, it won’t work as a comparison tool for businesses going through significant changes.
Accounting ratio analysis is a method that users of financial statements can use to obtain useful insights regarding different aspects of a business. There are many types of ratio analysis which mainly consists of profitability, liquidity and gearing ratios. Ratio analysis is important for several reasons for both businesses and their stakeholders, but it may come with certain limitations as well.