Accounting Ratios and Formulas: The Basics You Need to Know
These accounting ratios and formulas can keep your business’s finances in order.
- Running a small business requires maintaining accurate records, but bookkeeping may take a lot of time.
- You can easily assess the financial health of your organization using accounting ratios and formulae.
- Depending on the sort of firm you have, you can employ accounting ratios on a quarterly or annual basis.
- This article is for small business owners who wish to analyses their financial status using accounting ratios and formulae.
Running a small business requires having a fundamental grasp of accounting. It might take a lot of time and effort to keep up with all the different formulae and bookkeeping procedures. However, perseverance may provide you with a comprehensive view of your company’s present financial situation, allowing you to make crucial decisions.
Accurate documentation of items like accounts receivable and payable, inventories, and other company activities is the first step to sound accounting processes. Even while accounting software may do a lot of the tedious work for you if you’re wanting to further optimize your accounting process, it still helps to be familiar with the fundamentals of accounting, such as accounting ratios.
Accounting ratios provide easy methods for assessing the financial health of your business. Ratios are the accounting formulae that are most commonly employed in company analysis, according to Accounting Scholar. By using these ratios to analyses your finances, you might find patterns and other information that inform crucial business choices.
The most typical ratio kinds and the different formulae you can use within each category are shown below:
- Liquidity ratios
- Profitability ratios
- Leverage ratios
- Turnover ratios
- Market value ratios
Even though it might not be feasible to continuously evaluate all of these ratios at once, it’s important to choose a few that are important to the operations of your organization so you can keep informed about what’s occurring there.
Also Read: What Is an LLC?
What are accounting ratios?
It’s helpful to establish accounting ratios before we look at the many varieties. Accounting ratios gauge your company’s profitability and liquidity and might indicate whether it’s having money issues.
Depending on your business, you can apply these ratios on a quarterly or annual basis. For a physical and mortar business, for instance, a turnover ratio is crucial. The success of your business may be high-level analyzed using the appropriate accounting ratios.
Let’s examine some of the most popular accounting ratios to determine which ones could help your company.
By comparing current liabilities and liquid assets, these ratios are used to determine your company’s ability to pay its debts. This establishes the probability that your company will be able to settle short-term obligations. The following are some typical liquidity ratios:
Current ratio = current assets ÷ current liabilities.
This ratio is used to determine if your business can now pay off short-term obligations by selling off its assets.
Quick ratio = quick assets ÷ current liabilities.
This ratio is comparable to the current ratio above, with the exception that you only take into account your accounts receivable + cash plus marketable securities when measuring “quick” assets.
Net working capital ratio = (current assets – current liabilities) ÷ total assets.
You may determine the liquidity of your assets by calculating the net working capital ratio. A rising net working capital ratio shows that your company is spending more on liquid than on fixed assets.
Cash ratio = cash ÷ current liabilities.
This ratio demonstrates the degree to which your company can pay its obligations entirely out of cash. This ratio does not take into account any other assets.
Cash coverage ratio = (earnings before interest and taxes + depreciation) ÷ interest.
Similar to the cash ratio, the cash coverage ratio determines how likely it is for your company to be able to pay interest on its obligations.
Operating cash flow ratio = operating cash flow ÷ current liabilities.
The coverage of your current liabilities by cash flow is indicated by this ratio.
These ratios are used by accountants to assess a company’s profits in relation to its costs. Some typical profitability ratios are as follows:
Return on assets = net income ÷ average total assets.
The return-on-assets ratio shows how profitable a company is in relation to its assets.
Return on equity = net income ÷ average stockholder equity.
This ratio displays the return on shareholder investments for your company.