Types of Financial Ratios And Their Formulas

Firstly, we must know about the term Ratio, then we discuss about the types of Financial Ratios And Their Formulas.

Ratio

Ratio is a relationship of one variable to another. Ratios are important to make financial analysis because by comparing results, we can get accounting information of various financial statements throughout the Accounting Period. Such information is expressed in percentage or in other ways to analyze the performance of the Entrepreneur from past to present and from present to future prospective.

For Example, we can compare the Current Assets with Current Liabilities to check the working capital of the business. If the current assets are more than current liabilities, then the Entrepreneur is in a position to meet its short-term obligations. On the other hand, the firm is not running well to meet its daily expenses and pay its debts in time.

Now, let us know about Financial Ratios or Accounting Ratios

Financial Ratios or Accounting Ratios show relationship between two or more variable taken from various financial statements logically.

Types of Financial Ratios / Accounting Ratios

1. Current Ratio

It is the ratio of Current Assets to Current Liabilities. It shows the company’s ability to pay its short-term obligations and daily expenses to work properly. The ideal ratio may be 2:1 but it is not suitable for all businesses but it is clear that current assets should not be less than current liabilities, otherwise the entrepreneur is going well to manage the business.

The Formula For Current Ratio is:

Current Assets  =  Current Assets / Current Liabilities

                                                                       

          

2. Quick Ratio

Quick Ratio is the ratio of Quick Assets to Current Liabilities. This ratio is more liquid as it does not include Closing Inventory and Prepaid Expenses and these Current Assets are Least Liquid.

Quick Assets include Cash and those assets that are convertible into cash very quickly. These Assets include Cash, Marketable Securities, Accounts Receivable, etc.

Note: Liquidity means how much time a Current Asset takes to convert into Cash.

The Formula is given as:

Quick Ratio  =  Quick Assets / Current Liabilities

3. Working Capital Ratio

It is the difference between Current Assets And Current Liabilities. This ratio shows the entrepreneur’s ability to pay off its short-term obligations and meeting its daily expenses.

                                                         

Working Capital  =  Current Assets – Current Liabilities

4. Accounts Receivable Turnover Ratio / Debtors Turnover Ratio

We obtain this ratio, when we divide the Net Credit Sales by Average Accounts Receivable. It shows that how quickly, an entrepreneur converts Receivables into Cash or in other words how much time a firm takes to receive Cash From its Customers.

Accounts Receivable Turnover Ratio  =  Net Credit Sales / Average Accounts Receivable

                                                                                             

5. Accounts Receivable Period / Debtor Collection Period

If we divide 365 by Accounts Receivable Turnover Ratio, then we get this ratio. It indicates that how many days an entrepreneur takes to collect Receivable or to receive cash from customers in how many days.

Accounts Receivable Period  =  365 / Account Receivable Turnover Ratio

                                                                                           

6. Inventory Turnover Ratio / Stock Turnover Ratio

This ratio tells us about the relationship between Cost of Goods Sold and Average Inventory. It shows that how many times an entrepreneur sells that particular Inventory or Stock to it customers and replaces its inventory or stock over a specified period of time.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

7. Days To Sell Inventory Ratio

If we divide 365 days by Inventory Turnover Ratio, then we get this ratio. It shows that in how many days an entrepreneur sells its inventory or stock to its customers.

Days To Sell Inventory Ratio =  365 / Inventory Turnover Ratio

                                                                                                                                                                                  

8. Operating Cycle Ratio

It is the sum of Days To Sell Inventory and Accounts Receivable Collection Period. It shows that in how many days Cash invested in Inventory converts back into Cash. If an entrepreneur is good, then it can sell its products very quickly and get its investments + profits, finally, in the form of Cash.

Operating Cycle Ratio = Days To Sell Inventory + Days To Collect Receivables

                                                                                    

9. Debt Ratio

When we divide the Total Liabilities by the Total Assets, then we get this ratio. This ratio shows an Entrepreneur’s ability to pay its debts out of the total Assets. Whenever the entrepreneur fails to pay the debts then debts of the creditors must be paid first from the total assets and, then remaining if left out must be utilized against the rights of the Shareholders.

Debt Ratio   =  Total Liabilities / Total Assets

                                                            

10. Gross Profit

When we divide Gross Profit By Net Sales, it is obtained. It actually indicates that how much an entrepreneur earns profits on its products.

Gross Profit  =  Gross Profit / Net Sales

                                                         

11. Operating Expense Ratio

We obtain this ratio when we divide Operating Expenses by Net Sales. It shows that how effective is management of the business to control expenses of the business.

Operating Expense Ratio  =  Operating Expenses / Net Sales

                                                                                     

12. Operating Income

It is the difference between Gross Profit and Operating Expenses. This ratio shows profitability of the business operations’ activities.

Operating Income  =  Gross Profit – Operating Expenses

                                                                           

13. Net Income as a Percentage of Net Sales / Net Income Ratio

It is obtained by dividing Net Income with Net Sales. It shows that how effectively the management of the company controls the costs of the business.

Net Income as a Percentage of Net Sales  =  Net Income /  Net Sales

                                      

14. Return On Assets

This ratio is obtained when we divide Operating Income by Average Total Assets. It indicates that how much assets are productive regardless of their financial costs.

Return On Assets  =  Operating Income / Average Total Assets

                                                                                                                               

                          

15. Return On Equity

It is the ratio of Net Income to Average Total Equity. It shows how much return is earned on Shareholder’s Equity in the Business.

Return On Equity  =  Net Income / Average Total Equity

                                                                                                                                                      

16. Earnings Per Share

It is the ratio of Net Income to Number of Shares held by the shareholders in the company. It tells us that the total income of the company is contributed by each of the shares held by the shareholders in the company.

Earnings Per Share  =  Net Income / No. of Shares     

                                                                                                       

                                    

For Example, if the company has 50000 shares held by the shareholders (Owners) of the company and total net income for the Accounting Period is Rs.600000, then the Earnings Per Share is:

Earnings Per Share = 600000 / 50000 = Rs.12 Per Share.

So, Rs.12 is the Earnings Per share earned by the company during the Accounting Period.

So, it is all about Ratio, Financial Ratios or Accounting Ratios types and their formulas.