The Importance of Accounting Ratios Analysis
Accounting ratios analysis helps in the identification of the strengths and weaknesses of a business. Based on the financial reports it enables the business to measure its efficiency and profitability and provides a way of determining the relationship between one accounting variable to another on their financial statements. Over time a business can assess their performance and pick up on key indicators on whether improvements or changes are necessary.
The use of these ratios can assist a business to better understand:
- how they are tracking – their day to day spend and whether they are experiencing cash flow issues,
- the amount of staff a business has vs productivity achieved,
- how quickly their stock turns into a sale,
- your customer payments habits vs the terms of payment a business sets,
- how much money is being made for every $ of sales,
- pricing of stock – does this need adjusting due to inflation and overall costs increasing?
The above are just some examples of how ratios can be helpful in running a business. To give you a more in depth understanding of ratios we use regularly, and how they assist your business keep reading.
What are the advantages of ratio analysis?
- it simplifies the financial statements
- it helps in comparing businesses of varied sizes
- it assists with trend analysis – how a business is tracking; and
- it highlights valuable information in a simple form rather than performing an analysis of a financial statement
Are there any limitations I should be aware of when looking at ratio analysis?
- when comparing different businesses operating under different environmental conditions it does not consider the differing regulatory and market conditions, so they may be somewhat misleading;
- financial accounting information is affected by estimates and assumptions, accounting standards also may allow for different accounting policies, so comparability can sometimes be impaired;
What are the most important and useful accounting ratios and what will they help me determine for my business?
This is a measure of the degree to which assets of the business are financed by the debts and the shareholders equity of a business
Debt to equity ratio =
Total Liabilities divided by Shareholders Equity
Lower values of this ratio are favourable indicating less financial risk
Working Capital ratio
Working Capital =
Current Assets divided by Current Liabilities
Current Assets are assets that are expected to be realised in a year or within one operating cycle. Current Liabilities are obligations that are required to be paid over the same time frame. The more positive the working capital the less likely the company will have liquidity problems. A working capital ratio greater than one is good.
Inventory Turnover ratio
This is an efficiency turnover ratio that shows how effectively inventory is managed by comparing cost of good sold with average inventory for a particular period
Inventory turnover ratio =
Cost of Goods Sold divided by Average Inventory
It is important that the ratio is high because it indicates that the company is in control of its inventory (not buying too much or wasting storage space). The financial cost of carrying excessive inventory is a waste of resources.
Gross Margin ratio
Gross Margin ratio is the ratio of gross profit of a business to its revenue. It measures what proportion of revenue is converted into gross profit.
Gross margin =
(Revenue less Cost of Goods Sold) divided by Revenue
This ratio is a measure of profitability. In general, higher values are more favourable because more profit is available to cover non-production costs
Profit Margin ratio
This ratio measures the amount of net income earned with each dollar of sales generated. It shows how effectively a business can convert sales into net income.
Profit margin ratio =
Net Income divided by Net Sales
This is sometimes used in place of the profit margin ratio. It provides similar information.
Profitability ratio =
Operating Profit before Tax divided by Total Income
An extremely low profitability ratio would indicate that expenses were too high and there is a need to review expenses and/or a need to boost revenue without increasing expenses by a similar amount.
Debtor Days ratio
This is a measure of the number of days it takes a business to collect cash from its sales. In other words, it shows how well a business can collect cash from its customers. Both liquidity and cash flows increase with a lower debtor days measurement.
Days sales outstanding =
Accounts Receivable divided by Net Sales x 365
As you can see, ratio analysis is an effective way to evaluate the financial results of your business to gauge performance. These ratios assist in understanding the financial statements of your business. They identify certain trends over time and can be one measure for analysing the financial state of your business. These ratios can assist lenders and investors on whether the performance of the business is worth lending money to or investing in. A business who looks at these ratios will understand where their business is not performing and can therefore take action. Ultimately when a business compares performance, a clearer picture is given about their financial position therefore assisting to identify areas for improvement.