Understanding an Accounting Ratio
An accounting ratio compares two line items in a company’s financial statements, namely made up of its income statement, balance sheet, and cash flow statement. These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the fiscal year.
Fundamentals include the basic qualitative and quantitative information that contributes to the financial or economic well-being of a company and its subsequent financial valuation. Where qualitative information includes elements that cannot be directly measured, such as management experience, quantitative analysis uses mathematics and statistics to understand the asset and predict its movements.
Analyzing accounting ratios is an important step in determining the financial health of a company. It can often point out areas that are negatively affecting the profitability of a company and therefore need improvement. The efficiency of new management plans, new products, and changes in operational procedures, can all be determined by analyzing accounting ratios.
Accounting ratios also work as an important tool in company comparison within an industry, for both the company itself and investors. A company can see where it is positioned against its competitors and investors can use accounting ratios to determine which company is the better option.
Types of Accounting Ratios
Gross Margin and Operating Margin
The income statement contains information about company sales, expenses, and net income. It also provides an overview of earnings and the number of shares outstanding used to calculate earnings per share (EPS). These are some of the most popular data points analysts use to assess a company’s profitability.
Gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $70,000 and sales are $100,000, the gross profit margin is 70%. The higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion of revenues as profit rather than expenses.
Operating profit as a percentage of sales is referred to as operating margin. It is calculated by dividing operating profit by sales. For example, if the operating profit is $90,000 and sales are $100,000, the operating profit margin is 90%.
The balance sheet provides accountants with a snapshot of a company’s capital structure and one of the most important measures of which is the debt-to-equity (D/E) ratio. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1. The debt-to-equity ratio shows how much a business is leveraged; how much debt it is using to finance operations as opposed to its own internal funds.
The Quick Ratio
The quick ratio, also known as the acid-test ratio, is an indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we are only concerned with the most liquid assets, the ratio excludes inventories from current assets.
Dividend Payout Ratio
The cash flow statement provides data for ratios dealing with cash. For example, the dividend payout ratio is the percentage of net income paid out to investors through dividends. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement.
For example, if dividends are $100,000 and income is $300,000, the dividend payout ratio is calculated by dividing $100,000 by $300,000, which is 33%. The higher the dividend payout ratio, the higher percentage of income a company pays out as dividends as opposed to reinvesting back into the company.