Accounting Ratios: A Complete Guide for Students

Accounting ratios are essential tools for analysing a company's financial performance and position. They allow you to interpret financial statements quickly and meaningfully — comparing performance over time, against industry benchmarks or against competitors. Ratios are tested extensively in ACCA, CIMA and AAT exams, and are used daily by analysts, lenders and investors.

Profitability Ratios

Profitability ratios measure a company's ability to generate profit relative to revenue, assets or equity.

Gross profit margin = (Gross profit / Revenue) × 100. Shows the percentage of revenue remaining after deducting direct costs. A higher margin indicates stronger pricing power or cost control in production.

Operating profit margin = (Operating profit / Revenue) × 100. Shows profit after all operating costs but before finance costs and tax.

Net profit margin = (Net profit / Revenue) × 100. The ultimate measure of overall profitability after all costs.

Return on capital employed (ROCE) = (Operating profit / Capital employed) × 100. Measures how efficiently the business uses its capital to generate profit. Capital employed = Total assets minus current liabilities.

Liquidity Ratios

Liquidity ratios assess a company's ability to meet its short-term obligations.

Current ratio = Current assets / Current liabilities. A ratio above 1 indicates the company can cover its short-term debts. An ideal range varies by industry, but 1.5 to 2.0 is often cited as healthy.

Quick ratio (acid test) = (Current assets − Inventory) / Current liabilities. A stricter liquidity test that excludes inventory, which may not be quickly converted to cash. A ratio of at least 1.0 is generally considered satisfactory.

Efficiency Ratios (Activity Ratios)

Efficiency ratios measure how effectively a company manages its assets and liabilities.

Inventory days = (Inventory / Cost of sales) × 365. The average number of days inventory is held before sale. Lower is generally better (faster stock turnover).

Receivables days = (Trade receivables / Revenue) × 365. The average number of days customers take to pay. Lower indicates faster collection.

Payables days = (Trade payables / Cost of sales) × 365. The average number of days the company takes to pay its suppliers.

Gearing Ratios

Gearing ratios measure the extent to which a company is financed by debt relative to equity.

Gearing ratio = (Non-current liabilities / Total equity + Non-current liabilities) × 100. A higher gearing ratio indicates more debt financing and higher financial risk.

Interest cover = Operating profit / Finance costs. Shows how many times the company can cover its interest payments from operating profit. A ratio above 2 is generally considered safe; below 1.5 may raise concern.

Frequently Asked Questions

What is the most important accounting ratio?

There is no single "most important" ratio — different ratios are relevant for different purposes. Profitability ratios matter most for investors assessing returns, liquidity ratios are critical for creditors, and gearing ratios are important for lenders assessing financial risk.

How do I interpret accounting ratios?

Ratios are most meaningful when compared over time (trend analysis), against industry averages (benchmarking), or against specific competitors. A single ratio in isolation gives limited insight — context is everything.