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Accounting Ratios - Theory, Cheat Sheet of Financial Accounting

You will learn accounting ratio in details. Also this is a very good document for remembering things before exam. Go through the notes and do comment.

Typology: Cheat Sheet

2023/2024

Available from 11/28/2024

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What is Ratio Analysis?
Ratio analysis is a financial tool that uses mathematical calculations to evaluate a company's
financial performance. It involves comparing different line items from a company's financial
statements (income statement, balance sheet, and cash flow statement) to gain insights into its
profitability, liquidity, solvency, and efficiency. 
Why is Ratio Analysis Important?
Ratio analysis is crucial for various stakeholders, including:
Investors: To assess a company's investment potential and risk. 
Creditors: To evaluate a company's ability to repay loans. 
Management: To monitor performance, identify areas for improvement, and make
informed decisions. 
Types of Ratios
Ratio analysis categorizes financial ratios into several main types: 
1. Profitability Ratios:
oGross Profit Ratio: Measures the profitability of a company's core
operations.
Formula: Gross Profit / Net Sales x 100 
oNet Profit Ratio: Measures the overall profitability of a company after all
expenses.
Formula: Net Profit / Net Sales x 100 
oReturn on Equity (ROE): Measures the return generated for shareholders.
Formula: Net Income / Shareholders' Equity x 100 
oReturn on Assets (ROA): Measures the efficiency of asset utilization in
generating profits.
Formula: Net Income / Total Assets x 100 
2. Liquidity Ratios:
oCurrent Ratio: Measures a company's ability to meet short-term obligations.
Formula: Current Assets / Current Liabilities 
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What is Ratio Analysis? Ratio analysis is a financial tool that uses mathematical calculations to evaluate a company's financial performance. It involves comparing different line items from a company's financial statements (income statement, balance sheet, and cash flow statement) to gain insights into its profitability, liquidity, solvency, and efficiency. Why is Ratio Analysis Important? Ratio analysis is crucial for various stakeholders, including:  Investors: To assess a company's investment potential and risk.  Creditors: To evaluate a company's ability to repay loans.  Management: To monitor performance, identify areas for improvement, and make informed decisions. Types of Ratios Ratio analysis categorizes financial ratios into several main types:

  1. Profitability Ratios: o Gross Profit Ratio: Measures the profitability of a company's core operations.  Formula: Gross Profit / Net Sales x 100 o Net Profit Ratio: Measures the overall profitability of a company after all expenses.  Formula: Net Profit / Net Sales x 100 o Return on Equity (ROE): Measures the return generated for shareholders.  Formula: Net Income / Shareholders' Equity x 100 o Return on Assets (ROA): Measures the efficiency of asset utilization in generating profits.  Formula: Net Income / Total Assets x 100
  2. Liquidity Ratios: o Current Ratio: Measures a company's ability to meet short-term obligations.  Formula: Current Assets / Current Liabilities

o Quick Ratio (Acid-Test Ratio): Measures a company's ability to meet short- term obligations without relying on inventory.  Formula: (Current Assets - Inventory) / Current Liabilities

  1. Solvency Ratios: o Debt-to-Equity Ratio: Measures the proportion of debt to equity in a company's capital structure.  Formula: Total Debt / Total Equity o Interest Coverage Ratio: Measures a company's ability to meet interest payments on its debt.  Formula: EBIT / Interest Expense
  2. Efficiency Ratios: o Inventory Turnover Ratio: Measures how quickly inventory is sold and replaced.  Formula: Cost of Goods Sold / Average Inventory o Accounts Receivable Turnover Ratio: Measures how quickly a company collects payments from customers.  Formula: Net Credit Sales / Average Accounts Receivable Interpretation of Ratios Ratio analysis is most powerful when used in combination with other financial metrics and qualitative factors. Here are some key points to remember when interpreting ratios:  Benchmarking: Compare a company's ratios to industry averages, historical trends, and competitors' ratios.  Trend Analysis: Analyze changes in ratios over time to identify trends and potential issues.  Qualitative Factors: Consider factors like management quality, competitive landscape, and economic conditions. Limitations of Ratio AnalysisAccounting Methods: Different accounting practices can affect the comparability of ratios.  Timeliness: Financial statements are often released with a lag, limiting the timeliness of ratio analysis.  Focus on Historical Data: Ratios primarily rely on past performance, which may not accurately predict future trends. In Conclusion Ratio analysis is a valuable tool for understanding a company's financial health and performance. However, it should be used in conjunction with other financial data and qualitative analysis for a comprehensive assessment.