Accounting ratios are essential tools that help in analyzing and interpreting the financial health of a business. They provide insights into various aspects of a company’s performance, such as profitability, liquidity, efficiency, and solvency. In this tutorial, we’ll explore the top ten accounting ratios every business owner, investor, or financial analyst should know. We’ll use real-world examples and journal entries to illustrate how these ratios impact financial statements.
1. Current Ratio
Definition: The current ratio measures a company’s ability to pay off its short-term liabilities with its short-term assets.
Formula:
Example:
ABC Corp has current assets worth $120,000 and current liabilities of $80,000.
Calculation:
A current ratio of 1.5 indicates that ABC Corp has $1.50 in current assets for every $1 of current liabilities, suggesting good short-term financial health.
Journal Entry:
When ABC Corp pays off a short-term liability of $10,000:
Dr Accounts Payable $10,000
Cr Cash $10,000This reduces both current liabilities and current assets by $10,000, potentially improving the current ratio if current liabilities decrease more significantly than current assets.
2. Quick Ratio (Acid-Test Ratio)
Definition: The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
Formula:
Example:
ABC Corp has inventory worth $30,000 within its current assets of $120,000.
Calculation:
A quick ratio of 1.125 indicates that ABC Corp can cover its short-term liabilities without relying on the sale of inventory.
Journal Entry:
When ABC Corp sells inventory worth $5,000 for cash:
Dr Cash $5,000
Cr Inventory $5,000This transaction increases the quick ratio as it converts less liquid inventory into more liquid cash.
3. Debt-to-Equity Ratio
Definition: The debt-to-equity ratio measures a company’s financial leverage and shows the proportion of debt used to finance the company’s assets relative to shareholders’ equity.
Formula:
Example:
ABC Corp has total liabilities of $200,000 and shareholders’ equity of $250,000.
Calculation:
A ratio of 0.8 indicates that ABC Corp has $0.80 in debt for every $1 of equity, suggesting a balanced approach to financing.
Journal Entry:
When ABC Corp issues new equity worth $50,000:
Dr Cash $50,000
Cr Share Capital $50,000This increases shareholders’ equity, thereby reducing the debt-to-equity ratio.
4. Gross Profit Margin
Definition: The gross profit margin indicates the percentage of revenue that exceeds the cost of goods sold (COGS), showing how efficiently a company produces its goods.
Formula:
Example:
ABC Corp has revenue of $500,000 and COGS of $300,000.
Calculation:
A gross profit margin of 40% indicates that ABC Corp retains 40 cents of each dollar of revenue after covering COGS.
Journal Entry:
When ABC Corp records sales of $50,000 with a COGS of $30,000:
Dr Accounts Receivable $50,000
Cr Sales Revenue $50,000
Dr COGS $30,000
Cr Inventory $30,000This transaction maintains the gross profit margin as it reflects the relationship between sales and COGS.
5. Net Profit Margin
Definition: The net profit margin shows the percentage of revenue remaining after all expenses have been deducted, indicating overall profitability.
Formula:
Example:
ABC Corp has a net income of $80,000 and revenue of $500,000.
Calculation:
A net profit margin of 16% indicates that ABC Corp retains 16 cents of each dollar of revenue as net profit.
Journal Entry:
When ABC Corp incurs operating expenses of $20,000:
Dr Operating Expenses $20,000
Cr Cash $20,000This affects net income and, consequently, the net profit margin.
6. Return on Assets (ROA)
Definition: ROA measures how efficiently a company uses its assets to generate profit.
Formula:
Example:
ABC Corp has a net income of $80,000 and total assets of $600,000.
Calculation:
An ROA of 13.33% indicates that ABC Corp generates 13.33 cents of profit for every dollar of assets.
Journal Entry:
When ABC Corp purchases new equipment worth $50,000:
Dr Equipment $50,000
Cr Cash $50,000This increases total assets, affecting the ROA calculation.
7. Return on Equity (ROE)
Definition: ROE measures how effectively a company uses shareholders’ equity to generate profit.
Formula:
Example:
ABC Corp has a net income of $80,000 and shareholders’ equity of $250,000.
Calculation:
An ROE of 32% indicates that ABC Corp generates 32 cents of profit for every dollar of shareholders’ equity.
Journal Entry:
When ABC Corp declares dividends of $10,000:
Dr Retained Earnings $10,000
Cr Dividends Payable $10,000This reduces shareholders’ equity, impacting the ROE.
8. Inventory Turnover Ratio
Definition: The inventory turnover ratio measures how efficiently a company manages its inventory by calculating how many times inventory is sold and replaced over a period.
Formula:
Example:
ABC Corp has a COGS of $300,000 and an average inventory of $50,000.
Calculation:
An inventory turnover ratio of 6 indicates that ABC Corp sells and replaces its inventory six times a year.
Journal Entry:
When ABC Corp purchases inventory worth $40,000:
Dr Inventory $40,000
Cr Accounts Payable $40,000This increases inventory, impacting the inventory turnover ratio.
9. Accounts Receivable Turnover Ratio
Definition: The accounts receivable turnover ratio measures how efficiently a company collects revenue from its credit customers.
Formula:
Example:
ABC Corp has net credit sales of $400,000 and average accounts receivable of $40,000.
Calculation:
An accounts receivable turnover ratio of 10 indicates that ABC Corp collects its average accounts receivable ten times a year.
Journal Entry:
When ABC Corp receives payment of $20,000 from a customer:
Dr Cash $20,000
Cr Accounts Receivable $20,000This reduces accounts receivable, affecting the turnover ratio.
10. Earnings Per Share (EPS)
Definition: EPS measures the profit available to each outstanding share of common stock, indicating a company’s profitability per share.
Formula:
Example:
ABC Corp has a net income of $80,000, no preferred dividends, and 10,000 outstanding shares.
Calculation:
An EPS of $8 indicates that each share of ABC Corp’s common stock earns $8 in profit.
Journal Entry:
When ABC Corp issues new shares worth $30,000:
Dr Cash $30,000
Cr Share Capital $30,000This increases the number of outstanding shares, potentially affecting the EPS.
Conclusion
Understanding and utilizing these top ten accounting ratios can significantly enhance your ability to analyze a company’s financial health and make informed business decisions. Each ratio provides a unique perspective on different aspects of financial performance, from liquidity and profitability to efficiency and leverage. By incorporating these ratios into your financial analysis toolkit, you’ll be better equipped to assess the strengths and weaknesses of any business.