Understanding Financial Ratios Used in Accounting: A Comprehensive Guide

Natalya Yashina is a public accountant at DASM with more than 12 years of experience in accounting. She is a member of the Advisory and Accounting Committee of the Virginia CPA Society and serves on the board of directors of the Virginia CPA Society Educational Foundation. She is also the founder and executive director of Capital Accounting Advisory, LLC, an accounting consulting firm that offers technical accounting, project management and training services and solutions. Evaluating the health of a company in which you want to invest involves measuring its liquidity.

Liquidity refers to the ease with which a company can convert its assets into cash to pay its short-term obligations. The working capital ratio is a metric used to measure liquidity. It is calculated by dividing current assets by current liabilities. A working capital ratio of 1 may mean that a company may have liquidity problems and be unable to pay its liabilities in the short term.

However, the problem may be temporary and may improve later. A working capital ratio of 2 or more can indicate strong liquidity and the ability to pay short-term liabilities. On the other hand, it could also target a company that has too many short-term assets. Also called a “litmus test”, the rapid ratio is another measure of liquidity. It represents the ability of a company to pay its current liabilities with assets that can be converted into cash quickly.

The calculation of the quick ratio is current assets minus inventory minus prepaid expenses divided by current liabilities. The formula eliminates inventory because it can take time to sell and convert it into liquid assets. A quick ratio of less than 1 may indicate that there are not enough liquid assets to pay for short-term liabilities. The company may need to raise capital or take other steps.

On the other hand, it may be a temporary situation. When you buy a stock, you share in the company's future profits (or risk of loss). Earnings per share (EPS) are a measure of a company's profitability. Investors use it to understand the value of the company. Return on capital (ROE) measures the profitability and efficiency with which a company uses shareholder money to make profits.

For shareholders of common stock, ROE (expressed as a percentage) is calculated by taking net income (income minus expenses and taxes) calculated before paying dividends in common shares and after paying dividends in common shares and after paying dividends in preferred shares, and dividing the result by the total capital of the shareholders. You can then multiply the result by 100 to convert it to a percentage. The higher the profit margin, the more efficient the company will be in converting sales into profits. Along the same lines are earnings per share or EPS, another quick ratio used when evaluating future earnings. The yield-per-dividend/dividend yield ratio is the ratio between a company's current dividend and the current price of its shares.

The higher the profitability index, the better the company will be compared to other companies with a lower profitability index. For companies in the manufacturing and production industries with high levels of inventory, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations. A high receivables turnover rate shows that a company generates cash quickly from receivables. For example, a higher asset turnover rate (asset turnover ratio). The asset turnover ratio is the ratio between a company's net sales and total average assets, and it helps determine if the company generates sufficient revenues to justify holding a large amount of assets on the company's balance sheet. Determining individual financial ratios by period and tracking the change in their values over time is done to detect trends that may be developing in a company.

The comparison of financial ratios with those of the main competitors is done to identify if a company is performing better or worse than the industry average. Calculating accurate financial ratios and interpreting them help business leaders and investors make informed decisions. Financial creditors have committed to the company compared to what shareholders have committed to. The debt-to-capital ratio Debt-to-capital ratio The debt-to-capital ratio is a representation of the company's capital structure that determines the ratio of external liabilities to shareholder capital. The price-benefit ratio Price-benefit ratio The price-benefit ratio (PE) measures the relative value of corporate shares, i.

If this ratio is also low, it indicates that the company is in a better position, since it can meet its requirements with its funds. Book Value Per Share Ratio Book Value Per Share Ratio The Book Value Per Share (BVPS) formula evaluates the real value of common capital for each outstanding share, excluding preferred shares' value. Financial ratios are essential tools for investors when evaluating companies for potential investments or assessing their performance over time. This comprehensive guide provides an overview of some key financial ratios used in accounting such as working capital ratios, quick ratios, return on equity (ROE), profit margins, earnings per share (EPS), dividend yield ratios, inventory turnover rates, receivables turnover rates, asset turnover ratios, debt-to-capital ratios, price-benefit ratios and book value per share ratios.