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Accounting Ratios
Accounting Ratios

Accounting ratios are a tool that we can use to analyze an entity's performance over time and compare that entity to the industry norms.

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Written by Alex
Updated over 5 months ago

Accounting ratios or KPIs are a tool that we can use to analyze an entity's performance over time and compare that entity to the industry norms. Below follows our glossary of accounting ratios that are available and calculated in real-time for each entity connected to Syft:

Profit and Loss

Profitability Ratios

Profitability ratios are a class of financial metrics that are used to assess a entity's ability to generate earnings relative to its sales and operating costs.

Gross Margin

Gross Margin = Gross Profit / Sales

The gross margin represents the amount of sales profits that the entity retains after incurring the direct costs associated with producing and selling the goods and services it sells. The higher the margin, the more the entity retains on each dollar of sales to service its other costs and debt obligations.

Operating Margin

Operating Margin = Operating Expenses / Sales

The operating margin shows the efficiency of an entity's management by comparing the total operating expenses to total sales. The operating ratio shows how efficient an entity's management is at keeping costs low while generating sales. The smaller the ratio, the more efficient the entity is at generating sales versus operating expenses.

Net Margin

Net Margin = Net Profit / Sales

The net margin is equal to how much net profit is generated as a percentage of sales. The net profit margin illustrates how much of each dollar in sales collected by an entity translates into profit. The higher the ratio the better.

Interest Cover

Interest Cover = Earnings Before Interest and Tax (EBIT) / Interest Expense

The interest cover ratio is used to determine how easily an entity can pay interest on its outstanding debt. The interest cover ratio may be calculated by dividing an entity's earnings before interest and tax (EBIT) during a given period by the entity's interest payments due within the same period.

The interest cover ratio is also called “times interest earned.” Lenders, investors, and creditors often use this formula to determine an entity's riskiness relative to its current debt or for future borrowing. The higher the ratio the better as this indicates that the entity has sufficient earnings to settle interest repayments.

Balance Sheet

Liquidity Ratios

Liquidity ratios are an important class of financial metrics used to determine an entity’s ability to pay off current debt obligations without raising external capital. Liquidity ratios measure an entity's ability to pay debt obligations and its margin of safety through the calculation of metrics. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.

Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is a liquidity ratio that measures an entity's ability to pay short-term obligations, or those due within one year. It tells investors and analysts how an entity can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

Quick Ratio

Quick Ratio = (Cash + Receivables) / Current Liabilities


or


Quick Ratio = (Current Assets – Inventory) / Current Liabilities

The quick ratio is an indicator of an entity’s ability to meet its short-term obligations with its most liquid assets.

Since it indicates the entity’s ability to instantly use its near-cash assets (that is, assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio.

Accounts Receivable Days

Accounts Receivable Days = Average Accounts Receivable / Sales x Number of Days in the Period

The accounts receivable days ratio is used to quantify an entity's effectiveness in collecting its receivables or money owed by clients. The ratio shows how well an entity uses and manages the credit it extends to customers and how quickly that short-term debt is collected or is paid. The lower the ratio the better or the closer the ratio to, or below the credit terms offered to debtors, the better.

Accounts Payable Days

Accounts Payable Days = Average Accounts Payable / (Cost of Sales + Expenses) x Number of Days in the Period

Accounts Payable Days indicates the average days that an entity takes to pay all of its bills, invoices and expenses to suppliers, vendors and employees.

An entity with a higher accounts payable days ratio takes longer to pay its bills and expenses, which means that it retains the available funds for a longer duration. It may allow the entity an opportunity to utilize the available cash in a better way to maximize the benefits.

Solvency Ratios

Solvency ratios measure an entity’s ability to sustain operations indefinitely by comparing debt levels with equity.

Debt to Equity

Debt to Equity (D/E) = Total Liabilities / Total Equity

The ratio is used to evaluate an entity's financial leverage. It is a measure of the degree to which an entity is financing its operations through debt versus wholly owned funds. More specifically, a lower ratio reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.

DuPont Analysis

DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). Decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses in an entity.

There are three major financial metrics that drive return on equity (ROE): operating efficiency, asset use efficiency and financial leverage.

Operating Efficiency

Operating Efficiency = Net Profit / Sales

Operating efficiency (identical to Net Margin) refers to profitability or how much net profit is generated as a percentage of sales. Therefore, operating efficiency illustrates how much of each dollar in sales collected by an entity translates into profit.

Asset Use Efficiency

Asset Use Efficiency = Sales / Average Total Assets

Asset use efficiency refers to how effectively an entity is utilizing its assets to generate sales. The higher the ratio, the better, as this indicates that a smaller quantum of assets is generating a greater volume of sales.

Financial Leverage

Financial Leverage = Average Total Assets / Absolute Value of Average Equity

Financial leverage refers to the gearing of the entity or how much debt the entity has utilized to finance its business. The higher the value, the more debt the entity is using in its funding structure.

Return on Equity

Return on Equity = Net Profit / Absolute Value of Average Equity


or


Return on Equity = Operating Efficiency x Asset Use Efficiency x Financial Leverage

ROE is considered a measure of how effectively management is using an entity’s assets, leverage and expense minimization to create profits for shareholders. ROE can be increased by improving operating efficiency, asset use efficiency or by increasing financing leverage through more debt funding.

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