# Accounting Ratio: Definition and Types

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*— Investopedia / NoNo Flores*

> **Definition**
>
> An accounting ratio is an analysis tool used to evaluate a company's financial health by measuring the relationship between two figures from its financial statements.

## What Is an Accounting Ratio?

Accounting ratios, an important subset of financial ratios, are a group of metrics used to measure the management aptitude, efficiency, and [profitability](https://www.investopedia.com/financial-ratios-4689817) of a company based on its financial reports. They provide a way of expressing the relationship between one accounting data point to another and are the basis of [ratio analysis](https://www.investopedia.com/terms/r/ratioanalysis.asp). They also serve as a way to compare the firm's performance to its competitors.

### Key Takeaways

*   An accounting ratio compares two line items in a company’s financial statements that are made up of its income statement, balance sheet, and cash flow statement.
*   These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year.
*   Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.
*   Accounting ratios are used by the company to make improvements or monitor progress, as well as by investors.

## Why Accounting Ratios Matter

An accounting ratio compares two line items in a company’s [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp). These consist of its income statement, balance sheet, and cash flow statement. The ratios can be used to evaluate a company’s [fundamentals](https://www.investopedia.com/terms/f/fundamentals.asp) and provide information about the performance of the company over the last quarter or fiscal year.

Analyzing accounting ratios is an important step in determining the financial health of a company. They can often point out areas that are dragging the profitability of a company down and therefore need improvement. The effectiveness of new management plans, new products, and changes in operational procedures can all be determined by analyzing accounting ratios.

Accounting ratios also work as an important comparison tool. The company and its investors can see how it stacks up against its competitors.

> **Important**
>
> A thorough accounting analysis can be a complex task. Calculating an accounting ratio, on the other hand, is a simple process of dividing two line items found on a financial statement.

## Types of Accounting Ratios

### Gross Margin and Operating Margin

The [income statement](https://www.investopedia.com/terms/i/incomestatement.asp) contains information about a company's sales, expenses, and net income. It also provides an overview of earnings and the number of [shares outstanding](https://www.investopedia.com/terms/o/outstandingshares.asp) used to calculate [earnings per share](https://www.investopedia.com/terms/e/eps.asp) (EPS). These are some of the most popular data points that analysts use to assess a company’s profitability.

[Gross profit](https://www.investopedia.com/terms/g/grossprofit.asp) as a percent of sales is referred to as [gross margin](https://www.investopedia.com/terms/g/grossmargin.asp). It's calculated by dividing gross profit by sales. If gross profit is $80,000 and sales are $100,000, the gross profit margin would be 80%. The higher the gross profit margin, the better. It indicates that a company is keeping a higher proportion of [revenues](https://www.investopedia.com/terms/r/revenue.asp) as profit rather than using them to meet expenses.

[Operating profit](https://www.investopedia.com/terms/o/operating_profit.asp) as a percentage of sales is referred to as [operating margin](https://www.investopedia.com/terms/o/operatingmargin.asp). It's calculated by dividing operating profit by sales. If the operating profit is $60,000 and sales are $100,000, the operating profit margin would be 60%.

### Debt-to-Equity Ratio

The [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) provides you with a snapshot of a company’s capital structure. One of the most important measures of capital structure is the [debt-to-equity](https://www.investopedia.com/terms/d/debtequityratio.asp) (D/E) ratio.

It's calculated by dividing debt by [equity](https://www.investopedia.com/terms/e/equity.asp). If a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio would be two to one. The debt-to-equity ratio shows how much a business is leveraged—that is, how much debt it's using to finance operations rather than its internal funds.

### The Quick Ratio

The [quick ratio](https://www.investopedia.com/terms/q/quickratio.asp) is also known as the [acid-test ratio](https://www.investopedia.com/terms/a/acidtest.asp). It's an indicator of a company’s short-term [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) and measures a company’s ability to meet its short-term obligations with its most liquid assets. The ratio excludes inventories from current assets because we're only concerned with the most liquid assets in this case.

### Dividend Payout Ratio

The [cash flow statement](https://www.investopedia.com/investing/what-is-a-cash-flow-statement/) provides data for ratios dealing with cash. The [dividend payout ratio](https://www.investopedia.com/terms/d/dividendpayoutratio.asp) is the percentage of net income paid out to investors through [dividends](https://www.investopedia.com/terms/d/dividend.asp). Both dividends and [share repurchases](https://www.investopedia.com/terms/s/sharerepurchase.asp) are considered outlays of cash and can be found on the cash flow statement.

If dividends are $100,000 and income is $400,000, the dividend payout ratio is calculated by dividing $100,000 by $400,000, which works out to 25%. The higher the dividend payout ratio, the higher the percentage of income a company pays out as dividends rather than reinvesting back into the company.

## What Are Shares Outstanding?

Shares outstanding are those that are available to investors. They include shares held by company employees and institutional investors. The number can fluctuate when employees exercise stock options or if the company issues more shares.

## What Are Some Examples of Liquid Assets?

Liquid assets include cash and anything that can be easily converted to cash. They include marketable securities, government bonds, foreign currencies, and treasury bills.

## How Can an Investor Use Accounting Ratios?

Accounting ratios provide a view of a company's financial health. However, they're only one type of tool when you're assessing investments. They can measure a company's liquidity and profitability, but this information should be taken in light of other factors to get a complete picture of a company's sustainability and potential earnings.

## The Bottom Line

Accounting ratios can provide an accurate assessment of the profitability of a company over the last quarter or fiscal year. They include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, the gross margin, and the operating margin.

These are just a few examples of the many accounting tools that corporations and analysts use to evaluate a company; however. Many other tools highlight different aspects of a company, so you’ll want to explore and potentially use them as well.