What is an Accounting Ratio?

An accounting ratio is any one of several statistical measurements that are intended to make an assessment of the financial strength of a company. These ratios usually take two sets of statistics related to each other and divide one number into another to come up with the ratio. Ratios may be used, among other things, to judge how profitable a company is, how well it can pay off its debt obligations, and how efficient it might be. It is best to use an accounting ratio in conjunction with a company's past ratios and in comparison to the ratios of other companies in the same industry.

Investors looking to invest in a company typically attempt to gather as much information as possible about the company in question. Their best resources may be statistical information available on earnings reports and balance sheets. This information is also useful to credit companies deciding whether to start an account with a business. Combining two pieces of statistical information can create an accounting ratio that will shed light on some aspect of a company's business.

As an example of an accounting ratio, the current ratio may be the most basic of these ratios to measure a company's financial stability. To calculate the current ratio, the total amount of assets that a company has is divided by its liabilities. If the resulting number is high, the company is generally considered to be financially strong. A low current ratio is an indicator that a company could be struggling.

Using an accounting ratio without any context to attempt to gauge a company's financial standing might lead to some false assumptions. To use the current ratio again as an example, a company might have a low current ratio at the present time, but if it's a marked improvement from the ratio at the last accounting period, then the company's outlook might be positive. On the other hand, a company might have what looks like a high ratio, but if other companies in the same industry have better ratios, the company could actually be in trouble.

There is an applicable accounting ratio for practically every aspect of a company's business. Efficiency is measured by asset turnover ratios, which measure how well a company collects payments and uses inventory, while profitability ratios show a company's ability to generate income. Financial leverage ratios measure how well a company can meet its debt requirements, while dividend policy ratios are concerned with the dividends it pays out to investors and how those dividends affect financial growth.