What is an accounting ratio?
An accounting ratio is a simple arithmetic relationship that compares two numbers taken from a company’s financial statements (income statement, balance sheet, or cash flow statement). Analysts use these ratios to convert line‑item figures into standardized measures of profitability, liquidity, leverage, and cash distribution so companies can be compared over time and against peers.
Key concepts (short definitions)
– Gross margin: gross profit divided by sales; shows how much of each sales dollar remains after the cost of goods sold.
– Operating margin: operating profit divided by sales; shows how much of each sales dollar remains after operating expenses.
– Debt‑to‑equity (D/E) ratio: total debt divided by shareholders’ equity; a measure of leverage — how much financing comes from creditors vs. owners.
– Quick ratio (acid‑test): (current assets − inventory) ÷ current liabilities; a strict measure of short‑term liquidity using only the most liquid assets.
– Dividend payout ratio: dividends paid ÷ net income; the portion of profits distributed to shareholders as dividends.
– Shares outstanding: the total number of company shares held by investors, including institutional holders and employees.
– Liquid assets: cash or assets that can be converted to cash quickly with minimal price impact (examples: cash, marketable securities, government bonds, Treasury bills).
Why these ratios matter
– Standardization: Ratios turn raw accounting numbers into comparable metrics across companies and time periods.
– Diagnosis: They highlight areas such as low profitability, weak liquidity, heavy leverage, or a high dividend commitment.
– Monitoring: Management and investors can track the effect of new strategies, products, or cost controls by watching ratio changes.
Step‑by‑step: how to compute and use accounting ratios
1. Select the ratio you need and identify the required line items on the financial statements (income statement, balance sheet, cash flow statement).
2. Confirm the period or date for each item (e.g., quarterly income vs. balance sheet as of quarter end).
3. Plug numbers into the formula and compute the ratio.
4. Compare the result to:
– the company’s historical values (trend analysis),
– industry peers or sector averages (cross‑sectional comparison),
– common benchmarks or rule‑of‑thumb thresholds.
5. Ask follow‑up questions if a ratio looks extreme (e.g., is high debt seasonal? Are margins affected by one‑time charges?).
6. Combine multiple ratios for a fuller picture (profitability + liquidity + leverage).
Checklist before you interpret a ratio
– Are the input figures from the same reporting period and using the same accounting policies?
– Have there been significant one‑time items, acquisitions, or share issuances that distort trends?
– Are you comparing against appropriate peers (same industry and company size)?
– Do you understand whether ratios are influenced by non‑cash items (e.g., depreciation) or off‑balance‑sheet factors?
– Is seasonality likely to affect the values? (Retail sales, for example, spike in holidays.)
Worked numeric example (illustrative)
Assume a company reports:
– Sales = $100,000
– Gross profit = $80,000
– Operating profit = $60,000
– Total debt = $100,000
– Shareholders’ equity = $50,000
– Current assets = $50,000
– Inventory = $10,000
– Current liabilities = $20,000
– Net income = $400,000
– Dividends paid = $100,000
Calculate common ratios:
1) Gross margin = gross profit ÷ sales
= $80,000 ÷ $100,000 = 0.80 → 80%
Interpretation: 80 cents of every sales dollar remain after covering cost of goods sold.
2) Operating margin = operating profit ÷ sales
= $60,000 ÷ $100,000 = 0.60 → 60%
Interpretation: 60% of sales remain after operating expenses.
3) Debt‑to‑equity ratio = total debt ÷ shareholders’ equity
= $100,000 ÷ $50,000 = 2.0
Interpretation: The firm has $2 of debt for every $1 of equity (higher leverage).
4) Quick ratio = (current assets − inventory) ÷ current liabilities
= ($50,000 − $10,000) ÷ $20,000 = $40,000 ÷ $20,000 = 2.0
Interpretation: The company has $2 of very liquid assets per $1 of short‑term obligation.
5) Dividend payout ratio = dividends ÷ net income
= $100,000 ÷ $400,000 = 0.25 → 25%
Interpretation: The company distributes 25% of earnings to shareholders as dividends.
Limitations and cautions
– Ratios are a snapshot or short‑term summary and can be affected by accounting choices (e.g., depreciation methods) and non‑recurring items.
– Industry norms vary widely; a “good” ratio in one sector may be poor in another.
– Ratios do not replace qualitative analysis (business model, competitive position, management quality) or cash‑flow examination.
– Shares outstanding can change (e.g., option exercises, new issuances), affecting per‑share metrics like earnings per share.
Further reading (reputable sources)
– Investopedia — Accounting Ratio definition: https://www.investopedia.com/terms/a/accounting-ratio.asp
– U.S. Securities and Exchange Commission (Investor.gov) — How to Read Financial Statements: https://www.investor.gov/introduction-investing/investing-basics/how-read-financial-statements
– CFA Institute — Financial Statement Analysis resources: https://www.cfainstitute.org/en/research/foundation/2011/financial-statement-analysis
– Financial Accounting Standards Board (FASB): https://www.fasb.org/
Educational disclaimer
This explainer is for educational purposes only. It does not constitute personalized investment advice, recommendations, or price forecasts. Always consult qualified professionals and review a company’s full financial disclosures before making investment decisions.