How to Calculate Ratios in Accounting

Accounting ratios express the relationship between financial statement items, providing insights into a company’s financial health. Derived from balance sheets and income statements, they transform raw data into understandable metrics. These ratios help evaluate a business’s operational efficiency and financial stability, offering a clearer picture of performance and position.

Calculating Liquidity Ratios

Liquidity ratios measure a company’s ability to meet short-term financial obligations, those due within one year. They assess immediate financial solvency and capacity to convert assets into cash.

The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are resources expected to be converted into cash, consumed, or sold within one year, including cash, accounts receivable, and inventory. Current Liabilities are obligations due within one year, such as accounts payable, short-term debt, and accrued expenses. Both are found on the Balance Sheet. A higher ratio indicates greater short-term liquidity.

The Quick Ratio, also known as the Acid-Test Ratio, provides a more conservative view of liquidity by excluding inventory from current assets. Its formula is (Current Assets – Inventory) / Current Liabilities. Current Assets, excluding inventory, include cash, marketable securities, and accounts receivable, which are readily convertible to cash. Current Liabilities are the same as for the current ratio. All components are found on the Balance Sheet. This ratio focuses on assets quickly convertible to cash without relying on inventory sales.

The Cash Ratio is the most stringent liquidity measure, focusing only on a company’s most liquid assets. It is calculated as (Cash + Cash Equivalents) / Current Liabilities. Cash includes physical currency and bank deposits. Cash Equivalents are highly liquid investments readily convertible to known amounts of cash, such as money market funds and short-term government bonds. Current Liabilities are short-term obligations. All components are found on the Balance Sheet. This ratio indicates a company’s ability to cover short-term debts using immediate cash resources.

Calculating Solvency Ratios

Solvency ratios assess a company’s ability to meet long-term financial obligations, indicating financial stability over an extended period. They evaluate how a company finances its assets and sustains operations.

The Debt-to-Equity Ratio compares a company’s total debt to its shareholder equity. The formula is Total Debt / Shareholder Equity. Total Debt encompasses all short-term and long-term borrowings and liabilities. Shareholder Equity represents the owners’ stake in the company, calculated as total assets minus total liabilities. All components are found on the Balance Sheet. A lower ratio suggests less reliance on debt financing.

The Debt-to-Assets Ratio indicates the proportion of a company’s assets financed by debt. It is calculated as Total Debt / Total Assets. Total Debt includes all liabilities. Total Assets represent all economic resources owned by the company. All components are found on the Balance Sheet. This ratio provides insight into a company’s overall financial leverage.

The Times Interest Earned Ratio measures a company’s ability to cover interest expenses with operating earnings. The formula is Earnings Before Interest and Taxes (EBIT) / Interest Expense. EBIT, also known as operating income, represents a company’s profit from core operations before deducting interest and income tax. Interest Expense is the cost a company incurs on its borrowings. Both are found on the Income Statement. A higher ratio signifies a greater capacity to meet interest payments.

Calculating Profitability Ratios

Profitability ratios measure a company’s ability to generate earnings relative to revenue, assets, or equity. They evaluate operational effectiveness and overall financial success.

The Gross Profit Margin indicates the percentage of revenue remaining after accounting for the cost of goods sold. Its formula is (Gross Profit / Revenue) 100%. Gross Profit is calculated as Revenue minus the Cost of Goods Sold. Revenue represents the total income generated from a company’s primary operations. All components are found on the Income Statement. A higher gross profit margin suggests better control over production costs.

The Net Profit Margin measures the percentage of revenue left after all expenses, including taxes and interest, have been deducted. It is calculated as (Net Income / Revenue) 100%. Net Income, often referred to as the “bottom line,” is the final profit figure after all operating and non-operating expenses, interest, and taxes are accounted for. Revenue is the top-line figure. Both are found on the Income Statement. This ratio reflects the overall efficiency of a company’s operations.

Return on Assets (ROA) assesses how efficiently a company uses its assets to generate net income. The formula is Net Income / Average Total Assets. Net Income is obtained from the Income Statement. Average Total Assets are calculated by adding the total assets at the beginning and end of a period and dividing by two. Total assets are found on the Balance Sheet. A higher ROA indicates more effective asset utilization in generating profits.

Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders’ equity). It is calculated as Net Income / Average Shareholder Equity. Net Income comes from the Income Statement. Average Shareholder Equity is derived by averaging the shareholder equity at the beginning and end of a period. Shareholder equity is found on the Balance Sheet. This ratio shows how much profit a company generates for each dollar of equity.

Calculating Efficiency Ratios

Efficiency ratios, also known as activity ratios, assess how effectively a company utilizes assets and manages liabilities to generate sales and operations. They provide insights into how well a business converts resources into revenue.

Inventory Turnover measures how many times a company’s inventory is sold and replaced over a period. The formula is Cost of Goods Sold / Average Inventory. Cost of Goods Sold (COGS) represents the direct costs attributable to the production of goods sold by a company, found on the Income Statement. Average Inventory is calculated by adding the beginning and ending inventory balances for a period and dividing by two. Inventory figures are found on the Balance Sheet. A higher turnover indicates efficient inventory management.

Accounts Receivable Turnover indicates how efficiently a company collects its accounts receivable from customers. It is calculated as Net Credit Sales / Average Accounts Receivable. Net Credit Sales represent revenue from sales made on credit, less any returns or allowances, found on the Income Statement. Average Accounts Receivable is derived by adding the beginning and ending accounts receivable balances and dividing by two. Accounts receivable are found on the Balance Sheet. A higher turnover suggests effective credit policies and collection efforts.

Asset Turnover measures how efficiently a company uses its total assets to generate sales. The formula is Net Sales / Average Total Assets. Net Sales, or revenue, represent total sales after deducting returns, allowances, and discounts, found on the Income Statement. Average Total Assets are calculated by averaging the total assets at the beginning and end of a period. Total assets are located on the Balance Sheet. A higher ratio indicates a company is more effective in generating revenue from its assets.