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The Use of Financial Ratios in Accounting


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Financial Ratios in Accounting

Made popular by Benjamin Graham, the financial ratios in accounting are very important for a business to know its profitability and obligations for the financial year that passed. There are numerous financial ratios for different purposes like Gross Profit Ratio, Liquidity Ratio, etc. These ratios undoubtedly serve businesses with an accurate valuation, but the calculation part can be tricky. A businessman typically uses the following ratios.

  • Gross Profit Ratio:

    As the name suggests, this ratio states the profitability of a business before considering the amount of tax. To calculate this ratio, we divide the business’s gross profit by its net sales for the stipulated period. Then, we multiply it by 100 to arrive at the conclusion in terms of percentage. In accounting, we also know this ratio as the GP ratio.

  • Net Profit Ratio:

    Where the GP ratio suggests the profitability of business before taxes, NP Ratio or Net Profit Ratio states the net profitability of a business after deducting all the applicable taxes. The calculation of this ratio differs slightly from the GP ratio, as for numerator net profit after taxes and operating expenses are taken for the calculative purpose.

  • Current Ratio:

    Current Ratio or Working Capital Ratio is helpful in knowing the liquidity of a business. To calculate this ratio, we divide the current assets of a business by its current liabilities. This ratio also states the ability of a company to meet its short term and long-term obligations.

  • Debtors Aging Ratio:

    Debtors Ageing Ratio helps in knowing the number of days that takes a business to collect its debts. Thus, it’s also known as Debtors Days Ratio. To calculate this activity ratio, we divide the total trade receivables by the total amount of credit sales multiplied by 365 (days.)

  • Liquid Ratio:

    The liquid ratio states the liquidity of a business or in other words, it shows how efficiently a business can pay its short term and long-term liabilities. Current Ratio and Quick or Cash Ratio are the two liquid ratios.

Ratio Calculation in Xero:

To make these calculations simpler, Xero accounting software provides a unique feature of calculating all the required ratios under its ‘Custom Reports’ tab. It lets the users analyze their businesses and compare the same to get a sound understanding of their position through ratio calculations.

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