An accounting ratio that is also called a financial ratio is a relation of two numerical values from a company’s performance or its financial statement. Regardless of the industry of operation, business itself generates ratios. In their turn, investors and analysts use ratios as a financial tool to compare strong and weak points of a company or several companies. One ratio cannot be considered sufficient to conduct a financial analysis and provide a statement, while a set of ratios is rather beneficial for companies. (Kimmel, Weygandt, & Kieso, 2007).
The latter helps to understand changes occurring within the same company and between the organizations. In addition, organizations of different size may be contrasted. The revealed tendencies may be used while designing financial statements in both short-term and long-term periods.
There are several ratios, which compose three categories such as profitability, liquidity, and solvency. The category of liquidity focuses on identifying the amount of cash that can be received rapidly and involves quick ratio (acid test ratio), accounts receivable turnover ratio, inventory turnover ratio, etc. (Porter & Norton, 2015).
The quick ratio (acid test ratio) characterizes an organization’s ability to repay its short-term obligations through the sale of liquid assets. It is calculated as the ratio of the most liquid part of working capital (cash, receivables, and short-term financial investments) to short-term liabilities. It can also be calculated as the ratio of all current assets except stocks to short-term liabilities. The accounts receivable turnover ratio measures the speed of repayment of an organization’s receivables: how quickly it receives payment for the goods or services sold from its customers. It may be calculated as the ratio of net sales volume or sales volume on credit to the average for the period of the number of receivables.
The mentioned ratio is measured in the number of times per period. As for the inventory turnover ratio, it demonstrates how many times a company used the average available stock balance in a given period. This ratio characterizes the quality of the reserves and the effectiveness of their management as well as allows specifying the remains of unused, obsolete, or substandard reserves.
Another category of the ratios that may be discussed is solvency, namely, debt to equity ratio, debt service coverage ratio, and times interest earned ratio (Bodie, Kane, & Marcus, 2017). The first one can be identified as an indicator of the total liabilities to the total stockholders’ equity. It belongs to the group of the most important indicators of a company’s financial position, which includes similar in meaning coefficients of autonomy and financial dependence.
The debt service coverage ratio refers to a net income from commercial real estate for a certain period to the amount of the cost of servicing the loan for the same period. A greater ratio characterizes a higher quality. The times interest earned ratio is a financial indicator that measures the amount of profit received prior to the interest on the loan and the payment of taxes. The corporations use this ratio to assess the level of protection of creditors from non-payment of debts by a borrower.
Within an organization, the ratios are to be used to reveal internal weaknesses and strengths and identify further strategies. While the ratios are utilized to compare financial results with outside corporations, they serve as tools to specify a company’s position in the given industry, clarify competitiveness and potential, and understand others’ performance indicators.
References
Bodie, Z., Kane, A., & Marcus, A. J. (2017). Essentials of investments (10th ed.). New York, NY: McGraw-Hill.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2007). Financial accounting: Tools for business decision making (5th ed.). Hoboken, NJ: Wiley & Sons.
Porter, G.A. & Norton, C.L. (2015). Financial accounting (10th ed.). Boston, MA: Cengage Learning.