Accounting ratios

The essentials

An accounting ratio is a mathematical relationship between two related items of financial statements, expressed as a pure ratio, a percentage or a number of times. Ratios simplify data, help compare performance over time and with other firms, and point out strengths and weaknesses. They are grouped into four types.

Key points

• Liquidity ratios: Current ratio = Current assets ÷ Current liabilities. Quick (liquid) ratio = Quick assets ÷ Current liabilities, where quick assets = current assets − inventories − prepaid expenses.
• Solvency ratios: Debt-equity ratio = Long-term debts ÷ Shareholders' funds; Total assets to debt ratio; Proprietary ratio = Shareholders' funds ÷ Total assets; Interest coverage ratio = Net profit before interest and tax ÷ Interest on long-term debt.
• Activity (turnover) ratios: Inventory turnover = Cost of revenue from operations ÷ Average inventory; Trade receivables turnover = Net credit revenue ÷ Average trade receivables; Trade payables turnover = Net credit purchases ÷ Average trade payables; Working capital turnover = Revenue from operations ÷ Working capital.
• Profitability ratios: Gross profit ratio, operating ratio, operating profit ratio, net profit ratio, return on investment.
• Average inventory = (Opening + Closing inventory) ÷ 2.

Exam tips

Learn which items enter each formula. For "effect of a transaction" questions, compute the ratio before and after; when the ratio is above 1, equal decreases in both terms raise it.

Common mistakes

• Including inventory in quick assets.
• Using revenue instead of cost of revenue from operations for inventory turnover.