The ability to calculate and understand ratios in accounting helps managers and investors understand the financial structure of a company. Ratios are important in accounting and finance, because they can detect problems early. This allows managers to find solutions to financial issues. The three main categories of ratios include profitability, leverage and liquidity ratios. Knowing the individual ratios in each category and the role they plan can help you make beneficial financial decisions concerning your future.
Investors and business managers use profitability ratios to see if a company earns more revenue than what it spends on expenses. Profitability ratios help reveal the segments of a business that are the most profitable. Several main financial ratios fall under the category of profitability ratios, including gross profit margin, return on assets and return on equity. The gross profit margin analyzes how much of a profit a company makes on each sale. ROA shows how much a company’s assets impact profits, and ROE shows the ability of a company to take money invested in the business by shareholders to earn a profit.
Leverage ratios show how much debt a company acquired. Leverage ratios focus more on long-term debt, while liquidity ratios deal with short-term debt. The three main leverage ratios include the debt, debt-to-equity and interest-coverage ratios. The debt ratio shows the relationship between a company’s debts and its assets. If a company experiences a debt ratio greater than one, the company has more debt than assets on its balance sheet. The debt-to-equity ratio determines how much equity a company used to finance debts. Companies with a small amount of debt usually experience a debt-to-equity ratio less than one. The interest-coverage ratio determines a company’s ability to pay its interest expenses derived from debt obligations. A company with a high interest-coverage ratio is in a better financial position than a company with a low interest-coverage ratio.
Liquidity ratios show a company’s current assets in relation to current liabilities. The information used to calculate liquidity ratios comes from a company’s balance sheet. Important liquidity ratios are the current, quick and cash ratios. The current ratio determines a company’s liquidity. The quick ratio is a more conservative version of the current ratio. It uses a similar formula but does not include inventory in its calculation. The cash ratio determines the ability of a company to immediately pay for their current liabilities with liquid assets. Higher-leverage ratios show a company is in a better position to meet its debt obligations than a lower ratio.
Accounting ratios can indicate when a company is in financial trouble. Companies that effectively use accounting ratios may turn their financial situations around if they take corrective steps. Financial ratios also indicate that a company is financially healthy. Companies can use ratios to see which segments of their business excel and focus on achieving more success. Although accounting ratios fail to give investors and managers all they need to know about a company’s financial condition, they serve as good starting points.