Accounting ratios are a vital part of financial ratios. It is a metric used to calculate the profitability and performance of a firm based on its fiscal reports. It shows a link between one accounting to another and forms a base of ratio analysis.
It compares two units of a firm’s financial statements, prepared by combining balance sheet, cash flow statement and income statement. Most companies use this ration to calculate business production and achievement for the last quarter or financial year.
Uses of Accounting Ratios
A few essential uses of accounting ratios are compiled below.
- It forecasts future events of a company as past ratios record indicates profit, sales, trends in costs, and other similar facts.
- It established a relation between primary ratios and applied to set desirable balance and coordination. Usually, this is associated with budgetary control.
- By deploying the ratio, the company can control resources and utilize them effectively.
- Accounting ratios play a crucial role in imparting the financial status of a firm to shareholders.
- It measures current and future efficiency.
- It assists investors to make investment decisions by giving them the required information on both profitability and solvency. Therefore, they take investment decisions by considering both profitability and solvency ratios.
Types of Accounting Ratios
The ratio is used for a various requirement. Therefore, it is classified into four sections.
- Liquidity Ratios – The purpose of liquidity ratio is to estimate the company’s short-term solvency. It measures an organization’s ability to pay its current liabilities.
- Activity Ratios – It is applied to calculate the competence of management and making use of the assets effectively to produce sales and profits. It is also known as turnover ratios as it specifies the potential at which the assets can be converted into sales.
- Leverage or Capital Structure Ratios – The primary purpose of leverage ratios is to evaluate the long-term solvency of the business.
- Profitability Ratios – The profitability ratios are used to calculate the production efficiency of the firm.
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