Among the most important practical applications of accounting principles is management — the leadership and decision-making that's responsible for how a business's finances are distributed and leveraged to deliver profit. Managerial accounting is often concerned with two key aspects of financial practice: ratio analysis and variance analysis. Understanding how these modes of analysis can provide information for business decisions is important for all business managers.
Managerial accounting is a type of accounting that applies specifically to the decisions made by managers. Although all accounting is essentially the same, individuals who specialize in managerial accounting have more experience with the accounts and analysis most applicable to management decisions. By contrast, accountants in other fields — such as tax accounting — may not work as frequently with the tools that managers use in the decision-making process. In managerial accounting, ratio analysis and variance analysis provide valuable information about performance that helps managers allocate resources, develop growth strategies and find investors.
In managerial accounting, ratio analysis is the practice of figuring financial ratios that are important to business decisions and then using them to assess performance. The specific ratios that management finds most informative varies from business to business and industry to industry, but ratios usually provide data about profitability, leveraging or solvency, liquidity, the asset efficiency and the business's market value.
The profitability ratio gives managers an idea of how well their business is performing in terms of generating profit. Important profitability ratios include return on investment, or how much a firm earns as a percentage of total capital investment, and profit margin — or return on sales — the amount of net income generated per dollar of sales.
Ratio analysis tells managers and creditors how likely a business is to be able to repay its debts. These ratios are also called leverage ratios. Leverage ratios include the debt-to-capital ratio, which tells managers how much of the company's capital comes from owners and how much from creditors. Useful solvency ratios also compare the firm's assets to liabilities — the total debt ratio — and break down its debt by long- and short-term obligations.
Liquidity ratios have to do with the firm's cash flow and whether the assets available to be easily spent are adequate to meet immediate obligations. The most common liquidity ratios are the current ratio — current, or short-term, assets divided by current liabilities — and the quick ratio, or current assets, minus inventory, divided by current liabilities. The quick ratio is often more useful because "inventory that is not easily sold will not be helpful in meeting short-term obligations," according to Gale Cengage, a business management expert.
Finally, ratio analysis may also tell managers how effectively a business is using its assets and how the business's stock value compares to its profitability. Asset efficiency ratios, such as inventory turnover, tell the business how long it holds onto an asset — in this case, inventory — before it realizes a return. A business with higher inventory turnover is usually more profitable, as the business makes money only when inventory is purchased and then sold. Market value ratios — such as the price-to-earnings, or PE, ratio — represent the difference between a company's stock price and how much it earns.
In addition to the information about current performance that businesses gain from ratio analysis, decisions often rely on some expectation about the difference between expected or budgeted performance and the actual performance, as measured by a financial ratio. Variance is also used by managers in costing decisions: In a costing variance analysis, a manager considers the difference between the expected price of goods or labor and their actual price. This helps provide information about the sources of loss or gain, as well as helps create projections for the future.