Understanding Accounting Ratios
Accounting generates a large amount of numerical data. Only when condensed into ratios do these figures become comparable and relevant for management purposes. Ratios help assess a company’s liquidity, efficiency and profitability. This article provides an overview of key accounting ratios, how to interpret them and typical pitfalls in their analysis.
Meaning and Definition
Accounting ratios are condensed performance indicators derived from financial statements, primarily from the balance sheet and income statement and, depending on reporting standards, from the cash flow statement.
They support management, owners, banks and other stakeholders in assessing the financial situation in a structured manner.
Ratios are particularly valuable when:
- analysed over several periods to identify trends,
- compared with similar companies or industry benchmarks,
- interpreted in the context of the business situation (e.g. growth phase, seasonality, investment cycle).
Important: Individual ratios provide indications but do not replace an overall assessment. Their relevance depends on the quality of accounting data and the structure of the financial statements, including accounting policies, accruals and one-off effects.
Types of Accounting Ratios
In practice, accounting ratios can be grouped into three main categories:
- Liquidity ratios (short-term solvency)
- Profitability ratios (earning power)
- Balance sheet ratios (financing and asset structure)
Liquidity Ratios
Liquidity ratios indicate whether a company can meet its short-term obligations. Depending on the ratio, different levels of “immediately available” assets are considered.
Liquidity Ratio I (Cash Ratio):
Measures coverage of short-term liabilities using cash and cash equivalents.
Liquidity Ratio II (Quick Ratio):
Includes short-term receivables in addition to cash.
Liquidity Ratio III (Current Ratio):
Considers total current assets, usually including inventories.
Practical note: High liquidity is not automatically better. Excessively high cash balances may indicate unused capital, while low liquidity can signal early cash flow risks. Meaningful interpretation requires time comparison and linkage with liquidity planning.
Profitability Ratios
Profitability ratios measure how efficiently a company generates profit and whether the business model is sustainable.
Return on Sales:
Indicates profit generated per unit of revenue.
Return on Equity:
Shows the return earned on capital invested by owners.
Return on Total Capital:
Assesses profitability relative to total capital employed.
Practical note: For meaningful comparison, clarity is required regarding which profit figure is used and whether extraordinary effects distort results.
Balance Sheet Ratios
Balance sheet ratios provide insight into financing structure and asset allocation and are key indicators of stability and risk.
Equity Ratio:
Share of equity relative to total assets.
Fixed Asset Ratio:
Proportion of fixed assets in total assets.
Current Asset Ratio:
Share of current assets in total assets.
Practical note: Appropriate structures are highly industry-dependent. The decisive factor is whether the structure aligns with strategy, risk profile and financing model.
Analysis and Interpretation
Effective interpretation of ratios relies on comparison and context:
- Time comparison: development over several periods
- Consistency: uniform accounting methods and structures
- Industry comparison: positioning relative to peers
- Cause analysis: operational drivers behind changes
The goal is not “good-looking ratios” but decision-relevant transparency for management and planning.
