What do Ratios Have to do with Accounting?
Maybe a better question would be: what do ratios not have to do with accounting? Almost every aspect of accounting, past the daily transactions that are recorded by posting to journals produces ratios or percentages of some sort. In this paper, we'll take a look at some of the more common ratios, and the business application and meaning.
The first ratios that we're going to examine look at profitability; and the one you most frequently hear, is the P/E ratio, or the price to earnings ratio. The price to earnings ratio is found by dividing the price per share of common stock by the earnings per share of common stock. Although the computation is not difficult to grasp, the business application is not quite as easy. But in the big picture, the higher the P/E, the better if you're concerned with earnings potential.
The next most frequently used ratio measuring profitability is the EPS, or earnings per share on common stock. This ratio is computed by subtracting preferred dividends from net income, and dividing by the outstanding shares of common stock. What does this ratio tell us? Generally, it's used to determine the profitability of an investment. The last ratio we'll look at about profitability is concerned with the dividends per share of common stock. This ratio is computed by dividing the dividends by the outstanding shares of common stock. Why is this useful? If you're an investor, you buy common stock, and this ratio tells you the extent to which earnings are distributed to common stockholders.
Next, and perhaps the biggest area concerned with ratios from an accounting standpoint, is the measure of solvency. The accounting function of analysis is almost always concerned with business from a solvency or profit standpoint, and solvency is the most popular. Solvency of a business refers to the business' ability to cover expenses and debt. There are various methods for determining solvency, but the most popular ratios are working capital, current ratio, acid-test ratio and the ratio of fixed assets to liabilities. Working capital ratios are determined by subtracting current liabilities from current assets. That one is very simple. The current ratio is determined by dividing current assets by current liabilities. The acid-test ratio considers only the quickly solvent items, such as cash; it is computed by dividing quick assets by current liabilities. The ratio of fixed assets to liabilities is used by long-term creditors to determine a businesses worthiness and solvency. It is computed when you divide fixed assets by long-term liabilities.
If all this seems a little confusing, take heart. Ratios are mathematics mixed with accounting. Think of it as word problems for the accounting and business industry. Well, that really doesn't help does it? Since most everyone doesn't like word problems, either. Since many of you may choose careers other than business accounting, you will probably hire an individual to be concerned with P/E and dividends when it comes to your interests and investments, and unless you intend to run your own business, or deal in acquisitions, this probably won't be the meat and potatoes of your life. There, now that's a reason to smile!
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.