Accounting formulas, also known as financial ratios, express relationships among the amounts reported in the financial statements. These ratios can offer insights into the economic health of a business. They can also indicate the reasonableness of the assumptions implicit in any business plan forecasts. For example, by comparing the ratios of your business with the ratios of similar businesses, you can compare the financial characteristics of your business with those of other businesses. By comparing the ratios in your pro forma model with industry averages and standards, you also test your modeling assumptions for reasonableness.
Two general categories of accounting formulas, or financial ratios, exist: common size ratios and inter-statement ratios. Common size ratios convert a financial statement—usually a balance sheet or an income statement—from dollars to percentages. These ratios allow for comparisons of the assets, liabilities, revenues, owner equity, and expenses of businesses of various sizes. The comparison can be either at a point in time or as a trend over time.
Inter-statement ratios quantify relationships among amounts from different financial statements or from different parts of the same financial statement. Inter-statement ratios are an attempt to account for the fact that amounts usually cannot be interpreted alone, but must be viewed in the context of other key financial factors and events.
Common inter-statement ratios include the following formulas:
- Current Ratio
- The Current Ratio figures show the ratio of current assets to current liabilities. The current ratio provides one measure of a business’s ability to meet its short-term obligations.
- Quick Ratio
- The Quick Ratio figures show the ratio of the sum of the cash and equivalents plus the accounts receivable to the current liabilities. The quick ratio provides a more stringent measure of a business’s ability to meet its short-term financial obligations than other ratios.
- Working Capital to Total Assets
- The Working Capital to Total Assets figures show the ratio of working capital (the current assets minus the current liabilities) to the total assets. The Working Capital to Total Assets ratio is another measure of a firm’s ability to meet its financial obligations and gives an indication as to the distribution of a business’ assets into liquid and non-liquid resources.
- Receivables Turnover
- The Receivables Turnover figures show the ratio of sales to the accounts receivable balance. The Receivables Turnover ratio indicates the efficiency of sales collections. One problem with the measure as it’s usually applied is that both credit and cash sales might be included in the ratio denominator. Two potential shortcomings exist with this approach. First, the presence of the cash sales might make the receivables collections appear more efficient than is the case. Also, mere changes in the mix of credit and cash sales might affect the ratio, even though the efficiency of the receivables collections process has not changed.
- Inventory Turnover
- The Inventory Turnover row shows the ratio of the cost of sales to the inventory balance. The Inventory Turnover ratio calculates how long inventory is held. It can indicate depleted or excessive inventory balances.
- Times Interest Earned
- The Times Interest Earned row shows the ratio of the sum of the net income after taxes plus the interest income to the interest expense. The ratio indicates the relative ease with which the business is paying its financing costs.
- Sales to Operational Assets
- The Sales to Operational Assets row shows the ratio of sales revenue to net plant, property, and equipment. The ratio indicates the efficiency with which a business uses its operational assets to generate sales revenue.
- Return on Total Assets
- The Return on Total Assets row shows the ratio of the sum of the net income after taxes plus the interest expense to the total assets for each period. The ratio indicates the overall operating profitability of the business, expressed as a rate of return on the business assets.
- Return on Equity
- The Return on Equity row shows the ratio of the net income after taxes to the owner equity for each period. The ratio indicates the profitability of the business as an investment of the owners.
- Investment Turnover
- The Investment Turnover row shows the ratio of the sales revenue to the total assets. The ratio, like the Sales to Operational Assets ratio, indicates the efficiency with which a business uses its assets (for example, its total assets) to generate sales.
- Financial Leverage
- The Financial Leverage shows the difference between the return on the owner equity and the return on the total assets. The ratio indicates the increase or decrease in an equity return as a result of borrowing. A positive value indicates an improvement in the return on owner equity by using financial leverage; a negative value indicates deterioration in the return on owner equity.