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## Using Industry Average Ratios

Financial ratios are used to analyze a company’s strengths and weaknesses by looking at the ratio of various financial data to each other. Ratios convert financial information to a standardized format enabling them to be used to compare different companies to the industry average ratios. Company practices sometimes differ, which can produce different results so it is best to analyze a number of different ratios to get the most accurate overall comparison.

## Benefits of Using Industry Average Ratios in Accounting

It’s standard knowledge that nearly every company needs investors to be able to run efficiently. Call it a fail-safe if you’d like. That being said, how do these investors size the value of a given company before pumping their investments its way? By first analyzing their industry averages. They do this by:

- Checking the company’s financial ratios
- Analyzing their financial reports from accounting

This way, they’ll be able to tell if they are making a smart investment or hopping aboard a sinking ship! The great thing about these industry averages is that they can also benefit the company in the following ways:

**Attract more investments**– No one wants to be on the losing team. And that includes investors and creditors as well. For these guys to make a smart investment, they need assurance. And what better way by checking out the industry average of a company? If a company is performing above the industry benchmark, then you bet investors will be coming from all directions.**Important for calculating the debt-to-equity ratio**– This ratio is the holy grail for any small business operator as well as a medium-sized company. With this ratio, the operations department can be able to compare the value of investments in any funds obtained from creditors. This way, the department can be able to understand the portion of both equity and debt that can be used finance assets. If a company has a low ratio, then this means that their financially healthy to borrow money in the present as well as the future.**Used in calculating the return on investment**– Calculating the ROI helps the company or business owner know the rate at which money invested by stockholders is being returned. With the inclusion of industry averages, he or she can be able to tell if the investors will be satisfied with the return of investment.

**Types of Industry Average Ratios**

Let’s have a look at the different types of industry average ratios and how to solve them.

### Liquidity Ratios

A liquidity ratio is used to determine whether a company has the ability to pay its liabilities; both current and long-term. In simple terms, these ratios showcase the cash levels that a company has as well as how quickly they are able to liquidate their assets in order to pay off any pending liabilities as well as address their current obligations.

The importance of liquidity cannot be downplayed. It is the ability of a company to be able to raise cash or further convert their current assets into money. In most cases, it is quite easy for companies to convert their assets such as inventory, trading securities, as well as accounts receivables into cash. And this is the reason why they are included while performing liquidity calculations of a company.

There are different types of liquidity ratios as given below:

**Quick ratio **– the quick ratio test is used to determine how able a company is when it comes to paying the current liabilities it has, utilizing their quick assets. So what are quick assets? These are assets currently available in the company and can be converted to cash in less than 90 days. Cash assets include cash itself, the current accounts receivable, any short-term investments, and last but not least, marketable securities. The quick ratio is also known as the acid test ratio, and its origin spans back to the time of early gold miners who used acid to test the metals. If each metal passed the acid test without corrosion, then it was considered pure gold.

*Quick Ratio = (Cash + Cash Equivalents + Short Term Investments + Current Receivables)/Current Liabilities*

In some special cases, some companies will not give a breakdown of their quick assets on a given balance sheet. Hence, the quick ratio can still be calculated by subtracting the inventory plus the current prepaid assets from the current asset total as shown:

*Quick ratio = (Total Current Assets-Inventory – Prepaid Expenses)/Current Liabilities*

**EXAMPLE**

Suppose you are given the following financial information for a given store:

Cash: $15000

Accounts Receivable: $4000

Inventory: $3000

Stock Investments: $2000

Prepaid taxes: $400

Current Liabilities: $20,000

The quick ratio will be given as

($15000 + $4000 + $2000)/$20,000 = 1.05

With the above quick ratio, it means that a business owner can pay their current liabilities with their quick assets and still remain with some of them.

**Current ratio – **the current ratio (or working capital ratio) measures the ability of a company to pay its short-term liabilities with the current assets that it has. This ratio is an important part of liquidity because it determines the short-term liabilities within the coming year. So what does this mean for the given company in question? They have a very limited time period to come up with the funds to pay off the given liabilities. Current assets used to pay off liabilities include cash, marketable securities, and cash equivalents.

*Current ratio = Current assets/Current Liabilities*

**EXAMPLE**

Suppose you own a given business and would like to apply for a loan to help with its expansion. Your bank first asks for your balance sheet so that they can analyze your current debt levels. Say within your balance sheet you reported $150,000 as your current liabilities and $30,000 as current assets. Therefore, your current ratio would be calculated as 30,000/150,000 = 0.2

**Time interest earned ratio – **also known as the interest coverage ratio, it is used to measure the amount of income used by a company to cover any interest expenses in the near future. In some setups, this ratio is regarded as a solvency ratio because it calculates the ability of a company to make interest as well as its debt service payments. Usually, these interest payments are done over a long period of time; thus they are regarded as a fixed ongoing expense.

*Times Interest Earned Ratio = Income before Interest and Taxes/Interest Expense*

**EXAMPLE**

Say your income statement shows you made about $400,000 year before any interest expenses or any income taxes. Then you accrued an interest expense of $40,000 for the same year. The time interest ratio would be as follows: $400,000/$40,000 = 10 times

### Activity Ratios

Activity ratios are also known as efficiency ratios. They are used to determine how well a company utilizes their given assets in order to generate an income. These ratios usually focus on the time period that companies take to collect cash from say their customers, or the time it takes for companies to make sales. These ratios are utilized by management in order to improve the company and further attract outside investments and creditors who would like to profit from the company.

These ratios are used synonymously with profitability ratios (which we will discuss further down). Hence, meaning that companies which use their resources efficiently will become profitable.

There are different types of activity ratios as given below:

**Accounts receivable turnover ratio **– this ratio determines the number of times a business can convert its account receivable into money within a given time period. A turn is described as the number of times a company collects average receivables. For example, if a company has $30,000 average receivables in a year and collects $60,000 receivables in the same year, then it would have a double its accounts receivable because of collecting two average receivables. In short, this ratio showcases how efficient a company is at receiving credit sales from its customers.

*Accounts Receivable turnover ratio = Net Credit Sales/Average Accounts Receivable*

**Note:** Net credit sales are used instead of cash sales because credit sales can create receivables while cash sales cant.

**EXAMPLE**

Say you own a fishing gear store and you offer accounts to some of your return customers. At the end of the financial year, your balance sheet shows $30,000 in your accounts receivable, $80,000 of gross credit dales, and about $35,000 in returns. Your previous year’s balance sheet then shows $15,000 in accounts receivable

First and foremost, you’ll need to calculate your net credit sales as well as your average accounts receivable. This is given by:

*Net credit sales = Gross credit sales-returns*

$80,000 – $35,000 = $45,000

Then calculate the average accounts receivable as shown:

*(Beginning accounts receivable balance +Ending accounts receivable balance)/2*

($15,000 + $30,000)/2 = $22,500

Hence, the receivable turnover ratio will be given by:

$45,000/$22,500 = 2

Therefore, your turnover is 2; meaning that you collect your receivables twice a year or once after every 183 days. Therefore, whenever you make a credit sale, it will take your roughly 183 days to collect money from the given sale.

**Asset turnover ratio **– this ratio is used to determine the ability of a company to create sales from its current assets. This is done by comparing the net sales it has from the average total assets that are present. In simpler terms, this ratio shows how easily a company can generate sales from its assets.

*Asset Turnover ratio = Net Sales/ Average Total Assets*

By having a look at the formula, you can tell that a high ratio is desirable because it means that more money is made from each of the company’s assets.

**EXAMPLE**

Suppose you own a tech company that sells laptops and you have the following financial statement:

Beginning Assets – $60,000

Ending assets – $120,000

Net sales – $30,000

Your total turnover ratio will be as follows:

$30,000/(($60,000+$120,000)/2) = 0.33

Therefore, the ratio is 0.33; meaning that for every dollar currently present in your assets, you can only generate 33 cents as cash. Rather sad.

Learn more about the financial analysis ratios and how to use them in accounting!

**Inventory turnover ratio **– this ratio determines how effectively a company manages their inventory by making a comparison between the cost of goods sold to the average of the same inventory within a given time period. This ratio is vital because a company’s total turnover depends on stock purchasing as well as sales. Therefore, if a company purchases a large amount of inventory during a given financial year, they will have to sell as much in order to improve the turnover. The sales also have to match the inventory or else the inventory will have a poor turn.

*Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory*

**EXAMPLE**

Suppose you own a furniture company and in one financial year, you sold goods worth $1, 500,000 in your income statement. At the beginning of the year, you had an inventory worth $2,000,000 while at the end, it was at $1,000,000. Hence your turnover ratio would be calculated as: $1,500,000/ (($1,000,000 + $2,000,000)/2) = 0.6

This means that you sold roughly three-fifths of your inventory within the given year. Consider that a good year.

**Day sales inventory **– also known as the day’s inventory, this ratio determines the number of days a company has taken (or will take) to sell all of its current stock in its inventory. It is very vital because it is used by creditors and investors to determine cash flow, liquidity as well as the value of the company.

*Days Sales Inventory = (Ending Inventory/ Cost of Goods Sold) *365*

**EXAMPLE**

At the end of the financial year, a given company’s financial statement reads as shown below:

Ending inventory = $60,000

Cost of goods sold = $100,000

Therefore, day sales will be given as

($60,000/$100,000) *365 = 219 days

This means that a company has enough inventory for the next 219 days.

Find the answers to the essential financial ratio questions!

### Financial Leverage Ratios

They are also known as equity or debt ratios and determine the value of equity that a company has by taking a look at its overall debt. This is done by comparing the debt to its equity assets or shares outstanding. These ratios also show what share of company assets are under the shareholders as compared to the creditors.

The different types of financial leverage ratios are given as shown below:

**Debt ratio – **this is a solvency ratio that determines the total number of a company’s liabilities as compared to its total assets in percentage form. In simple terms, it showcases a company’s ability to use its assets in order to pay off any and all liabilities it has.

*Debt Ratio = Total Liabilities/ Total Assets*

**EXAMPLE**

Suppose you have a candy shop with the following financial statement:

Total Assets = $150,000

Total liabilities = $30,000

Debt ratio = $30,000/$150,000 = 0.2

The debt ratio is 0.2

**Debt to equity ratio **– the debt to equity ratio is used to determine the percentage of total debt to total equity of a given company. It is vital because it helps the company determine the percentage of financing that is contributed by both investors and creditors of the company.

*Debt to Equity ratio = Total Liabilities/Total Equity*

**EXAMPLE**

Given the following information of a given company:

Line of credit – $150,000

Mortgage – $600,000

Investment – $1.5million

Debt to equity ratio is given as shown:

($150,000 + $600,000)/$1,500,000 = 0.5

**Equity ratio – this is a solvency ratio that determines financed assets by the owner by comparing it with the equity of the said company. This ratio is important because it shows the total number of assets owned by the investors and secondly, shows the company’s debt leverage.**

*Equity ratio = Total Equity/ Total Assets*

**EXAMPLE**

Given the following from the financial statement of a given company:

Total assets – $150,000

Total liabilities – $50,000

According to the accounting equation, we can say the total equity is $100,000.

Therefore, $100,000/ $150,000 = 0.67

This means that 67% of assets are under the ownership of the shareholders. This is normally considered a healthy ratio.

## Profitability Ratios

These ratios are used to showcase the ability of a company to generate profits from all its operations by comparing both its income statement accounts as well as categories. In simple terms, it focuses on the ROI (return of investment) of a given company. It is vital because it helps investors and creditors determine whether a company is making enough profits from its operational costs.

There are different types of profitability ratios as follows:

**Gross margin ratio –** this is a ratio used to determine how profitable a company will be if it sells its entire inventory to a merchandise.

*Gross Margin ratio = Gross Margin/ Net Sales*

**EXAMPLE**

Given the following information from a company’s financial statements:

Inventory expenditure: $150,000

Inventory sell: $400,000

Refunded sales $50,000

Then, the gross margin ratio will be calculated as follows:

($350,000- $150,000)/ ($400,000-$50,000) = 0.57

**Profit margin ratio –** this ratio is also known as the return on sales ratio. It is used to determine the net income earned from every sale generated. This is done by comparing the net income of the company to its net sales. This ratio is important to investors and creditors as they can use it to measure the effectiveness of a company when it comes to converting sales into their net income.

*Profit Margin ratio = Net income/Net sales*

**EXAMPLE**

Suppose you own a shop and would like to determine your PMR with the following information:

Net sales = $500,000

Net income =$1,000,000

Therefore,

500,000/1,000,000 = 0.5 = 50%

**Return on assets ratio – **the ROA, also known as the return on total assets, is used to determine the net income from total assets within a given time period.

*Return on Assets Ratio = Net income/ Average total assets*

**EXAMPLE**

Given the following information in a company balance sheet:

Beginning assets – $800,000

Ending assets – $1,500,000

Net income – $25,000,000

ROA is given as shown below:

$25,000,000/ (($800,000 + $1,500,000)/2) = 21.7*100 = 2170%

This means that for every dollar invested, it produced $21.7 of net income.

**Return on capital employed –** this is a ratio that determines how efficient a company is when it comes to generating profits by comparing its net operating profit against its capital employed.

*Return on Capital Employed = Net Operating profit/Employed Capital*

In special cases where the employed capital is not given, it is calculated by:

*Capital employed = Total assets – Current liabilities*

**EXAMPLE**

Given the following financial information:

Net operating profit- $150,000

Total assets- $110,000

Current liabilities= $30,000

Then: $150,000/($110,000-$30,000)= 1.875

Therefore, every dollar invested earns the company $1.875.

**Return On Equity Ratio – **this** is a ratio that determines the ability of a company to generate profits as a result of its shareholder investments. In simpler terms, it shows how much profit is made from every dollar of stockholder equity.**

*Return on Equity Ratio = Net Income/ Shareholder’s equity*

**EXAMPLE**

Given the following from a company’s financial statement:

Net income – $100,000

Issued preferred dividends – $10,000 a year

12,000, $6 par common shares

Therefore:

Return on Equity ratio = $100,000 – $10,000/($12,000*$6) = 1.25

This means that for every dollar of shareholder equity, the company profits $1.25

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## Market Value Ratios

Also known as Market Prospect Ratios, these ratios are used to determine the stock of publicly trading companies to the dividend rates and earnings. Market ratios are used by investors to analyze the price of the stock and to figure out the present and future market value of the company. Some of the market value ratios include:

**Earnings per share ratio- **this is the net income that is earned as per the outstanding shares of stock. This ratio is used to show the level of profitability that a company has from its shareholder basis alone.

*Net Income – Preferred Dividends/ Weighted Average Common Shares Outstanding*

**EXAMPLE**

Given the following information:

Net income – $50,000

Weighted Averages – $6,000

Preferred dividends – $2

Therefore, $50,000-$2/ $6,000= $8

This means that each shareholder would receive $8 that year.

**Price-earnings ratio – **this ratio is used to determine the market value of the stock. In simpler terms, it is used to determine how much the market is willing to pay for a company’s stock according to its current earnings. It is vital because it helps investors determine future earnings per share.

*Price Earnings ratio = Market Value Price per share/Earnings per share*

**EXAMPLE**

Given the following information from a company’s financial statement:

Current stock trading – $40 per share

Earnings per share – $5

Hence:

$40/ $5 = $8

This translates to stating that current investors are okay to part with $8 for every dollar that is earned.

**Dividend payout ratio –** this** ratio determines the distribution percentage of the net income given to every shareholder through dividends. **

*Dividend Payout Ratio = Total dividends/Net Income*

**EXAMPLE**

Given the following information from a company’s balance sheet;

Net income – $15,000

Dividends issued – $3000

Therefore, $3000/ $15000 = 0.2 = 20%

This means that the company pays out 20% of its net income to the shareholders.

**Dividend yield ratio –** this ratio is used to determine the cash dividends paid to shareholders in relation to the market value of each share. This ratio is vital because it helps investors know how much they will receive in return from dividends or through market appreciation.

*Dividend Yield = Cash Dividends per share/Market Value Per share*

**EXAMPLE**

Given the following information from a company’s financial books;

Market price per share – $20

Money paid in dividends – $25,000

Total shares present – $1000

Hence ($25,000/1000)/$20 = 1.25

This means that investors receive $1.25 for every dollar that they invest in the given company.

Comparing the ratios obtained for a company against average industry ratios gives a good idea of how well a company is doing in the field. There are many different ways of analyzing a company. If you aren’t sure how to do the analysis you need our company provides accounting assignment help.

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