Ratios in accounting are important when determining the financial well being of your business a ratio analysis is one of the most powerful tools used in financial management. Ratios are determined by the information in your financial statements and are only as valid as the information used to calculate them. Ratios are good indicators of how well your business is performing but cannot be relied on to tell the whole story.
Ratios should be reviewed as a group and not as stand-alone indicators of your business. Some of the most utilized ratios are as follows:
Gross Profit Ratio calculates the gross profit in relation to net sales and is calculated as follows:
Gross Profit Ratio = Gross profit/Net Sales
The gross profit ratio indicates how much of each sales dollar is available to meet expenses and profits after paying for the goods that were sold.
The Current Ratio calculates general liquidity and is most widely used to make the analysis for short term liquidity of a firm and is calculated by:
Current Ratio = Current Assets/Current Liabilities
The Average Collection period Ratio represents the average number of days for which a firm has to wait before its debtors are converted into cash.
Average Collection Period = (Trade Debtors × No. of Working Days) / Net Credit Sales
Debt to Equity Ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.
Debt Equity Ratio = External Equities / Internal Equities
There are ratios that help determine profitability, liquidity, activity, debt, and market. Profitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return. Liquidity ratios measure cash availability to pay debt, activity ratios measure the effectiveness of the company’s use of resources, debt ratios determine the company’s ability to repay long-term debt, and market ratios measure investor response to owning a company’s stock and also the cost of issuing stock. Ratios can help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion and assist management and owners in diagnosing the financial health of their company.