This chapter covers the technique of accounting ratios for analysing the information contained in financial statements for assessing the solvency, efficiency
Explanation -The quick ratio or acid test ratio is a liquid- ity ratio that measures the ability of a com- pany to pay its current liabilities when they
Accounting ratios are calculated from the financial statements to arrive at meaningful conclusions pertaining to liquidity, profitability, and solvency
[Class XII : Accountancy] 337 Expression of ratios: Ratios are expressed in following four ways: Pure Ratio Like 2:1 All liquidity and solvency ratios
Financial Ratios Covers Information from Accounting 201 and 202 Financial ratios are useful indicators of a firm's performance and financial situation
financial statements, it is termed as accounting ratio Helpful in comparative analysis: The ratios are not being calculated for one year only
Class discussion; ? Homework on various question types; ? Quiz on formula of accounting ratios; ? Test on calculation and analysis of accounting
ACCOUNTANCY ACCOUNTING RATIOS www topperlearning com 2 ACCOUNTING RATIOS Introduction to Accounting Ratio and Ratio Analysis
interpret a full range of accounting ratios 14 1 Introduction Historically, of course, financial statements have been prepared for the benefit of
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Financial Ratio Cheatsheet
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Table of contents
Liquidity Ratios
Solvency Ratios
Market Prospect Ratios
Coverage Ratios
CPA Exam Ratios to Know
CMA Exam Ratios to Know38
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Liquidity Ratios
Quick Ratio / Acid Test Ratio
Current Ratio
Working Capital Ratio
Times Interest Earned
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Quick Ratio
The quick ratio or acid test ratio is a liquid
come due with only quick assets. Quick verted to cash within 90 days or in the sidered quick assets.
The quick ratio is often called the acid
test ratio in reference to the historical use was pure gold. If metal failed the acid test metal and of no value. a company can quickly convert its assets into cash in order to pay off its current li
The acid test ratio measures the liquidity
these capital assets will not only hurt the company it will also show investors that current operations aren't making enough
company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay that the company has twice as many
Current Ratio
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rent assets. The current ratio is an impor
This means that a company has a limited
amount of time in order to raise the funds This means that companies with larger amounts of current assets will more easily
The current ratio helps investors and credi
tors understand the liquidity of a company current assets. So a current ratio of 4 would mean that the company has 4 times more
A higher current ratio is always more favor
shows the company can more easily make means the company isn't making enough from operations to support activities. In
Sometimes this is the result of poor collec
The current ratio also sheds light on the
company is weighted down with a current
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Working Capital Ratio
cause it shows the liquidity of the company.
The reason this ratio is called the working
capital ratio comes from the working capi tal calculation. When current assets to work. The working capital ratio trans forms the working capital calculation into
Since the working capital ratio measures
current assets as a percentage of current indicates the current assets equal current would have to sell all of its current assets in is often referred to as negative working capital. outsiders that the company can pay all of assets left over or positive working capital.
Times Interest Earned Ratio
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erage ratio that measures the proportion to cover interest expenses in the future.
In some respects the times interest ratio
Since these interest payments are usually
The times interest ratio is stated in num
tio indicates how many times a company ratios. company makes enough income to pay for its total interest expense 4 times over. is 4 times higher than its interest expense for the year. company with a much higher times inter can afford to pay its interest payments when they come due. Higher ratios are less risky while lower ratios indicate credit risk.
Solvency Ratios
Equity Ratio
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Debt to Equity Ratio
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quidity ratio that compares a company's uity ratio shows the percentage of com
This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar.
that investors and creditors have an equal ratio are considered more risky to credi tors and investors than companies with a to make the payments. haven't funded the operations as much don't have as much skin in the game as the creditors do. This could mean that in forming well. Lack of performance might the reason why the company is seeking
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Equity Ratio
The equity ratio is an investment leverage
or solvency ratio that measures the amount the company to the total assets. nancial concepts of a solvent and sustain how much of the total company assets are the investors will end up with the remaining assets.
The second component inversely shows
The equity ratio measures how much of a
in the company. This is what they are on the hook for. The inverse of this calcula tion shows the amount of assets that were equity ratios show new investors and credi vestments. ally the case for several reasons. Higher potential shareholders that the company is worth investing in since so many inves higher ratio also shows potential creditors
less risky to lend future loans.Companies with higher equity ratios should than companies with lower ratios.
the industry. Exact ratio performance de marks.
Debt Ratio
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this shows how many assets the company ties.of a company. Companies with higher levconsidered highly leveraged and more risky for lenders.
This helps investors and creditors analysis
percentage of total assets. As with many less risky. This means that the company has company's assets and the shareholders own the remainder of the assets. company would have to sell off all of its
Asset Turnover Ratio
Inventory Turnover Ratio
Days" Sales in Inventory
Acccounts Receivable Turnover
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ciency ratio or activity ratio that measures
A turn refers to each time a company col
would have turned its accounts receiv at collecting its credit sales from customers. from customers in 90 days while other take up to 6 months to collect from customers. a ratio of 2 means that the company col is collecting is money from customers ev ery six months. indication of the quality of credit sales and tio shows that credit sales are more likely
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Asset Turnover Ratio
ing net sales with average total assets. In a company can use its assets to generate sales.
The total asset turnover ratio calculates net
sales as a percentage of assets to show how many sales are generated from each over ratios mean the company is using its ciently and most likely have management net sales of a company equals the aver the company is generating 1 dollar of sales for every dollar invested in assets. others. To get a true sense of how well a
dustry.The total asset turnover ratio is a general ciently a company uses all of its assets. This gives investors and creditors an idea of how a company is managed and uses its assets to produce products and sales.
Sometimes investors also want to see how
asset turnover ratio and the working capi tal ratio are turnover ratios similar to the asset turnover ratio that are often used classes.
Inventory Turnover Ratio
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cy ratio that shows how effectively inven goods sold with average inventory for a period. This measures how many times av erage inventory is turned" or sold during many times a company sold its total av erage inventory dollar amount during the
sold its 10 times over.over depends on two main components stock purchasing. If larger amounts of incompany will have to sell greater amounts of inventory to improve its turnover. If the company can't sell these greater amounts other holding costs.
The second component is sales. Sales
have to match inventory purchases other wise the inventory will not turn effectively.
Inventory turnover is a measure of how
turn. This shows the company does not pany can effectively sell the inventory it
This measurement also shows investors
how liquid a company's inventory is. Think to the company. This measurement shows how easily a company can turn its inven tory into cash.
Creditors are particularly interested in this
lateral for loans. Banks want to know that
Inventory turns vary with industry. For in
er turns than the exotic car industry.
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Days" Sales in Inventory
also called days inventory outstanding days sales in inventory ratio shows how many days a company's current stock of inventory will last.
This is an important to creditors and inves
tors for three main reasons. It measures
Both investors and creditors want to know
days sales in inventory shows how fast the company is moving its inventory. In other
This calculation also shows the liquidity of
inventory. Shorter days inventory outstand ing means the company can convert its the inventory is extremely liquid.
The days sales in inventory is a key com
ponent in a company's inventory man agement. Inventory is a expensive for a lescence.
Management wants to make sure its inven
inventories to sell within the next 90 days. costing the company extra money.
It only makes sense that lower days inven
higher ratios.
Gross Margin Ratio
Return on Assets
Return on Capital Employed
Return on Equity
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Gross Margin Ratio
ness to the net sales. This ratio measures age markup on merchandise from its cost. tory that can go to paying operating ex penses.
Gross margin ratio is often confused with
are completely different. Gross margin ra tio only considers the cost of goods sold gin ratio on the other hand considers other expenses. can sell its inventory. It only makes sense
Higher ratios mean the company is selling
age. costs are down.The second way retailers can achieve a sive and customers will shop elsewhere.
A company with a high gross margin ratios
mean that the company will have more money to pay operating expenses like it also measures the percentage of sales plaination.
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of net income earned with each dollar of income and net sales of a company. In what percentage of sales are left over af
Creditors and investors use this ratio to
measure how effectively a company can convert sales into net income. creditors want to make sure the company cate the expenses are too high and the expenses. internal management to set performance goals for the future. what percentage of sales is made up of tain level of sales.
This ratio also indirectly measures how well
a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this keeping expenses constant or keep rev enues constant and lower expenses.
Since most of the time generating addi
the same industry. This ratio is also effec tive for measuring past performance of a company.
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Return on Assets Ratio
that measures the net income produced ing net income to the average total assets. during a period.
Since company assets' sole purpose is to
investors see how well the company can
You can look at ROA as a return on invest
ment for the company since capital assets vests money into capital assets and the re
The return on assets ratio measures how
effectively a company can turn earn a return on its investment in assets. In other pany can covert the money used to pur costs of acquiring the assets in the return
pense in the formula.It only makes sense that a higher ratio is shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA raas well. ROA is most useful for comparing companies in the same industry as different industries use assets differently. For inexpensive equipment while software companies use computers and servers.
Return on Capital Employed
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Return on capital employed or ROCE is
each dollar of capital employed gener ates. cause it shows how effectively assets are
performing while taking into consideration more useful ratio than return on equity to evaluate the longevity of a company.
EBIT is often reported on the income state
The return on capital employed ratio
employed.
Investors are interested in the ratio to see
ing strategies. Companies' returns should loosing money. pany's amount of assets can either hinder or help them achieve a high return.
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Return on Equity Ratio
ers investments in the company. In other stockholders' equity generates.
So a return on 1 means that every dollar of
common stockholders' equity generates 1 dollar of net income.
This is an important measurement for po
money to generate net income.
ROE is also and indicator of how effective
to fund operations and grow the company. pany. Unlike other return on investment investor's point of viewnot the compa company's investment in assets or some
thing else. indicates that the company is using its investors' funds effectively. Higher ratios are nies' ratios in the industry. Since every industry has different levels of investors and companies outside of their industries very effectively.
Earnings Per Share
Price Eanings P/E Ratio
Dividend Payout Ratio
Dividend Yield
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Earnings Per Share
measures the amount of net income earned per share of stock outstanding. In each share of stock would receive if all standing shares at the end of the year.
Earnings per share is also a calculation
enced on how many shares are outstand split its earning amongst many more shares of stock compared to a smaller company.
Earning per share is the same as any prof
holders.Although many investors don't pay much share ratio often makes the stock price of a company rise. Since so many things can drastically.
Price Earnings P/E Ratio
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ket prospect ratio that calculates the mar ket value of a stock relative to its earnings the price earnings ratio shows what the on its current earnings.
Investors often use this ratio to evaluate
Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future.
earnings. Investor speculation and de mand also help increase a share's price over time.
The price to earnings ratio indicates the
earnings. As a company's earnings per value per share. A company with a high
P/E ratio usually indicated positive future
performance and investors are willing to pay more for this company's shares. rent and future performance. This could
In general a higher ratio means that inves
tors anticipate higher performance and growth in the future. It also means that companies with losses have poor PE ratios. ratio is only useful in comparing like com panies in the same industry. Since this ratio
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Dividend Payout Ratio
The dividend payout ratio measures the
uted to shareholders in the form of divi pany decides to keep to fund operations shareholders.
Investors are particularly interested in the
to know if companies are paying out a tors. and tech companies rarely give dividends shareholders in 2012. investors' interest so much that they are dend percentages. Inventors can see that tually need money for its operations.
Since investors want to see a steady
ysis is important. A consistent trend in this ratio is usually more important than a high or low ratio.
Since it is for companies to declare divi
a single high ratio does not mean that much. Investors are mainly concerned a company that has a payout ratio of 20 percent for the last ten years will continue holders. ward trend of payouts is alarming to inves fallen a percentage each year for the last ny can no longer afford to pay such high poor operating performance.
Dividend Yield
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measures the amount of cash dividends tive to the market value per share. The how their investment in stock is generating
ciation.Investors invest their money in stocks to appreciation. Some companies choose to investors' interest. These shares are often called income stocks. Other companies choose not to issue dividends and instead shares are often called growth stocks.
Investors can use the dividend yield for
ment in stocks.
Investors use the dividend yield formula
ting from their investment in stocks. In other dividends they are getting for every dollar that the stock is worth.
A company with a high dividend yield
pays its investors a large dividend com pared to the fair market value of the stock.
This means the investors are getting highly
compensated for their investments com pared with lower dividend yielding stocks.
A high or low dividend yield is relative to
the industry of the company. As I men dividends at all. So even a small dividend might produce a high dividend yield ratio
Coverage Ratios
Fixed Charge Coverage Ratio
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Fixed Charge Coverage Ratio
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interest earned ratio or the times interest coverage ratio. culation. rather than percentages. to. Lower ratios show creditors and inves
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Debt Service Coverage Ratio
ing its net operating income with its total this ratio compares a company's avail and future creditors are particularly inter est in it.
Creditors not only want to know the cash
levels. This is why a higher ratio is always er ratio indicates that there is more income
A ratio of less than one means that the company doesn't generate enough opmust use some of its savings.
ratios tend to have more cash and are on time. The two sections that tend to have ratios pop up in questions are FAR
Find more about the CPA Exam
Return on Assets
Working Capital
Acid Test
Times Interest Earned
Inventory Turnover
Days in Sales Days in Inventory
Margin of Safety
Return on Equity
EVA
Earnings per Share
P/E ratio
Book Value per Common Share
Current Ratio
Working Capital
Quick Ratio
Cash Ratio
Fixed charge coverage
Interest coverage
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Inventory turnover
Days sales in inventory
Operating cycle
Cash cycle
Total asset turnover
Fixed asset turnover
Price earnings ratio
Book value per share
Diluted EPS
Earnings yield
Dividend payout ratio
Shareholder return
Breakeven point in units and dollars
Margin of safety
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