Accounting / Bookkeeping Basics: Accounting Ratios

Accounting Ratios provide key measurements for analyzing a business’s health. Ratios are a tool to compare one business against industry standards or another similar business.

The ratios you will learn are:
-  The current ratio
-  The quick ratio
-  Return on assets
-  Return on equity
-  Net profit margin
-  Gross profit margin Liquidity Ratios

Liquidity ratios determine how easily a business will be able to meet its short term obligations. With liquidity ratios, the higher the number the better.

Liquidity ratios include:
-  the current ratio
-  the quick ratio

Current Ratio
The current ratio calculates a business ability to pay current liabilities with current assets. It compares what the business owns comparted to what it owes.
It is presented like any other ratio, with two numbers separated by a colon. Anything above 2:1 is considered acceptable.

The formula for current ratio is:
Current Assets ÷ Current Liabilities

Using the numbers from the sample balance sheet: 11,500 ÷ 4,500 = 2.6:1
The business has a current ratio of approximately 2.6:1. That means it can pay it current liabilities 2.6 times out of its current assets.

Quick Ratio
This ratio is very similar to Current Ratio, except that it removes inventory from the calculation of assets, on the assumption that inventory is harder to get rid of. Anything above 1.5:1 is considered acceptable.

The formula for the quick ratio is: (Current Assets - Inventory) ÷ Current Liabilities
Using the numbers from the sample balance sheet: (11,500 - 1,500) ÷ 4,500 = 2.4:1
The business has a quick ratio of approximately 2.4:1, meaning it can pay it current liabilities 2.4 times out of its current assets less inventory.

Profitability Ratios
Profitability ratios allow you to make comparisons of profitability between businesses of different sizes. For example, the net income of Walmart is going to dwarf your local supermarket profit. However the business with higher profitability ratios is the more profitable.

Return on Assets
Return on assets is a measure of how efficiently a business uses it assets. The higher the percentage the more efficient the business.
The formula is: Net Income ÷ Total Assets
Using the data from the sample income statement and balance sheet: 3,000 ÷ 12,500 = .26 (x 100 to make a %) = 26% Not a bad return!

Return on Equity
This ratio determines how efficiently the business uses the owner’s funds.

The formula is: Net Income ÷ Shareholder Equity

Using the data from the sample income statement and balance sheet from earlier in this book:
3,000 ÷ 8,000 = 37.5%

Net and Gross Profit Margin
These two ratios measure the amount of money that the business earns as a percentage of overall revenue.
The results of both equations are expressed as a percentage. The higher the percentage the more efficient the business.

Gross Profit Margin
Gross profit margin measures how efficiently a business used it materials and labor in the production of the goods it sold. Gross profit margin takes into account only the cost of making the product or service. The higher the gross profit margin the better because the business retains more of each dollar of sales, which means more money left over to pay operating and expenses.

The formula is: Gross Profit ÷ Gross Sales

Net Profit Margin
The net profit margin shows what the business has earned after selling its products and paying all expenses – the true bottom line. The higher the percentage the better. It demonstrates who efficient a business is at converting sales into profit.

The formula is: Net Profit ÷ Gross Sales
Using the data from the sample income statement and balance sheet: 3,300 ÷ 22,000 = 15%

Main points to remember
-  The current ratio calculates a business ability to pay current liabilities with current assets.
-  The quick ratio is very similar to Current Ratio, except that it removes inventory from the calculation of assets.
-  Return on assets is a measure of how efficiently a business uses it assets.
-  Return on equity determines how efficiently the business uses the owner’s funds.
-  Gross profit margin measures how efficiently a business used it materials and labor in the production of the goods it sold.
-  The net profit margin shows what the business has earned after selling its products and paying all expenses.