What Is an Accounting Ratio?

Accounting ratios, an important sub-set of financial ratios, are a group of metrics used to measure the efficiency and profitability 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.

Understanding an Accounting Ratio

An accounting ratio compares two line items in a company’s financial statements, namely 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.

Analyzing accounting ratios is an important step in determining the financial health of a company. It can often point out areas that are bringing the profitability of a company down and therefore need improvement. The efficacy 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 tool in company comparison within an industry, for both the company itself and investors. A company can see how it stacks up against its peers and investors can use accounting ratios to determine which company is the better option.

A thorough accounting analysis can be a complex task, but calculating accounting ratios is a simple process of dividing two line items found on a financial statement, that provide a quick form of clear analysis to a business owner or investor.

Types of Accounting Ratios

Gross Margin and Operating Margin

The income statement contains information about company sales, expenses, and net income. It also provides an overview of earnings and the number of shares outstanding used to calculate earnings per share (EPS). These are some of the most popular data points analysts use to assess a company’s profitability.

Gross profit as a percent of sales is referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. The higher the gross profit margin, the better, as it indicates that a company is keeping a higher proportion of revenues as profit rather than expenses.

Operating profit as a percentage of sales is referred to as operating margin. It is calculated by dividing operating profit by sales. For example, if the operating profit is $60,000 and sales are $100,000, the operating profit margin is 60%.

Debt-To-Equity Ratio

The balance sheet provides accountants with a snapshot of a company’s capital structure, one of the most important measures of which is the debt-to-equity (D/E) ratio. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1. The debt-to-equity ratio shows how much a business is leveraged; how much debt it is using to finance operations as opposed to its own internal funds.

The Quick Ratio

The quick ratio, also known as the acid-test ratio, is an indicator of a company’s short-term liquidity and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we’re only concerned with the most liquid assets, the ratio excludes inventories from current assets.

Dividend Payout Ratio

The cash flow statement provides data for ratios dealing with cash. For example, the dividend payout ratio is the percentage of net income paid out to investors through dividends. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement.

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

The examples above are just a few of the many accounting ratios that corporations and analysts utilize to evaluate a company. There are many more that highlight different aspects of a company.

What Is the Accounts Payable Turnover Ratio?

The accounts payable turnover ratio is a short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. Accounts payable turnover shows how many times a company pays off its accounts payable during a period.

Accounts payable are short-term debt that a company owes to its suppliers and creditors. The accounts payable turnover ratio shows how efficient a company is at paying its suppliers and short-term debts.

The AP Turnover Ratio Formula


$\begin{aligned} &\text{AP Turnover}=\frac{\text{TSP}}{(\text{BAP + EAP})/2}\\ &\textbf{where:}\\ &\text{AP = Accounts payable}\\ &\text{TSP = Total supply purchases}\\ &\text{BAP = Beginning accounts payable}\\ &\text{EAP = Ending accounts payable}\\ \end{aligned}$​AP Turnover=(BAP + EAP)/2TSP​where:AP = Accounts payableTSP = Total supply purchasesBAP = Beginning accounts payableEAP = Ending accounts payable​

Calculating the Accounts Payable Turnover Ratio

Calculate the average accounts payable for the period by adding the accounts payable balance at the beginning of the period from the accounts payable balance at the end of the period.

Divide the result by two to arrive at the average accounts payable. Take total supplier purchases for the period and divide it by the average accounts payable for the period.

Decoding Accounts Payable Turnover Ratio

The accounts payable turnover ratio shows investors how many times per period a company pays its accounts payable. In other words, the ratio measures the speed at which a company pays its suppliers. Accounts payable is listed on the balance sheet under current liabilities.  

Investors can use the accounts payable turnover ratio to determine if a company has enough cash or revenue to meet its short-term obligations. Creditors can use the ratio to measure whether to extend a line of credit to the company.

A Decreasing AP Turnover Ratio

A decreasing turnover ratio indicates that a company is taking longer to pay off its suppliers than in previous periods. The rate at which a company pays its debts could provide an indication of the company’s financial condition. A decreasing ratio could signal that a company is in financial distress. Alternatively, a decreasing ratio could also mean the company has negotiated different payment arrangements with its suppliers.

An Increasing Turnover Ratio

When the turnover ratio is increasing, the company is paying off suppliers at a faster rate than in previous periods. An increasing ratio means the company has plenty of cash available to pay off its short-term debt in a timely manner. As a result, an increasing accounts payable turnover ratio could be an indication that the company managing its debts and cash flow effectively.

However, an increasing ratio over a long period could also indicate the company is not reinvesting back into its business, which could result in a lower growth rate and lower earnings for the company in the long term. Ideally, a company wants to generate enough revenue to pay off its accounts payable quickly, but not so quickly the company misses out on opportunities because they could use that money to invest in other endeavors.

AP Turnover vs. AR Turnover Ratios

The accounts receivable turnover ratio is an accounting measure used to quantify a company’s effectiveness in collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the credit it extends to customers and how quickly that short-term debt is collected or is paid.

The accounts payable turnover ratio is used to quantify the rate at which a company pays off its suppliers. Accounts payable turnover shows how many times a company pays off its accounts payable during a period.

Accounts receivable turnover shows how quickly a company gets paid by its customers while the accounts payable turnover ratio shows how quickly the company pays its suppliers.

Limitations of AP Turnover Ratio

As with all financial ratios, it’s best to compare the ratio for a company with companies in the same industry. Each sector could have a standard turnover ratio that might be unique to that industry.

A limitation of the ratio could be when a company has a high turnover ratio, which would be considered as a positive development by creditors and investors. If the ratio is so much higher than other companies within the same industry, it could indicate that the company is not investing in its future or using its cash properly.

In other words, a high or low ratio shouldn’t be taken on face value, but instead, lead investors to investigate further as to the reason for the high or low ratio.

Example of the Accounts Payable Turnover Ratio

Company A purchases its materials and inventory from one supplier and for the past year had the following results:

• Total supplier purchases were $100 million for the year.
• Accounts payable was $30 million for the start of the year while accounts payable came in at $50 million at the end of the year.
• The average accounts payable for the entire year is calculated as follows:
• ($30 million + $50 million) / 2 or $40 million
• The accounts payable turnover ratio is calculated as follows:
• $100 million / $40 million equals 2.5 for the year
• Company A paid off their accounts payables 2.5 times during the year.

Assume that during the same year, Company B, a competitor of Company A had the following results for the year:

• Total supplier purchases were $110 million for the year.
• Accounts payable of $15 million for the start of the year and by the end of the year had $20 million.
• The average accounts payable is calculated as follows:
• ($15 million + $20 million) / 2 or $17.50 million
• The accounts payable turnover ratio is calculated as follows:
• $110 million / $17.50 million equals 6.29 for the year
• Company B paid off their accounts payables 6.9 times during the year. Therefore, when compared to Company A, Company B is paying off its suppliers at a faster rate.

What Is Accounts Receivable Financing?

Accounts receivable (AR) financing is a type of financing arrangement in which a company receives financing capital related to a portion of its accounts receivable. Accounts receivable financing agreements can be structured in multiple ways usually with the basis as either an asset sale or a loan.

Understanding Accounts Receivable Financing

Accounts receivable financing is an agreement that involves capital principal in relation to a company’s accounts receivables. Accounts receivable are assets equal to the outstanding balances of invoices billed to customers but not yet paid. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payment required within one year.

Accounts receivable are one type of liquid asset considered when identifying and calculating a company’s quick ratio which analyzes its most liquid assets:

Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable Due within One Year) / Current Liabilities

As such, both internally and externally, accounts receivable are considered highly liquid assets which translate to theoretical value for lenders and financiers. Many companies may see accounts receivable as a burden since the assets are expected to be paid but require collections and can’t be converted to cash immediately. As such, the business of accounts receivable financing is rapidly evolving because of these liquidity and business issues. Moreover, external financiers have stepped in to meet this need.

The process of accounts receivable financing is often known as factoring and the companies that focus on it may be called factoring companies. The best factoring companies will usually focus substantially on the business of accounts receivable financing but factoring in general may be a product of any financier. Financiers may be willing to structure accounts receivable financing agreements in different ways with a variety of different potential provisions.​

Structuring

Accounts receivable financing is becoming more common with the development and integrations of new technologies that help to link business accounts receivable records to accounts receivable financing platforms. In general, accounts receivable financing may be slightly easier for a business to obtain than other types of capital financing. This can be especially true for small businesses that easily meet accounts receivable financing criteria or for large businesses that can easily integrate technology solutions.

Overall, there are a few broad types of accounts receivable financing structures.

Asset Sales

Accounts receivable financing is typically structured as an asset sale. In this type of agreement, a company sells accounts receivable to a financier. This method can be similar to selling off portions of loans often done by banks.

A business receives capital as a cash asset replacing the value of the accounts receivable on the balance sheet. A business may also need to take a write-off for any unfinanced balances which would vary depending on the principal to value ratio agreed on in the deal.

Depending on the terms, a financier may pay up to 90% of the value of outstanding invoices. This type of financing may also be done by linking accounts receivable records with an accounts receivable financier. Most factoring company platforms are compatible with popular small business bookkeeping systems such as Quickbooks. Linking through technology helps to create convenience for a business, allowing them to potentially sell individual invoices as they are booked, receiving immediate capital from a factoring platform.

With asset sales, the financier takes over the accounts receivable invoices and takes responsibility for collections. In some cases, the financier may also provide cash debits retroactively if invoices are fully collected.

Most factoring companies will not be looking to buy defaulted receivables, rather focusing on short-term receivables. Overall, buying the assets from a company transfers the default risk associated with the accounts receivables to the financing company, which factoring companies seek to minimize.

In asset sale structuring, factoring companies make money on the principal to value spread. Factoring companies also charge fees which make factoring more profitable to the financier.

BlueVine is one of the leading factoring companies in the accounts receivable financing business. They offer several financing options related to accounts receivable including asset sales. The company can connect to multiple accounting software programs including QuickBooks, Xero, and Freshbooks. For asset sales, they pay approximately 90% of a receivables value and will pay the rest minus fees once an invoice has been paid in full. 

Loans

Accounts receivable financing can also be structured as a loan agreement. Loans can be structured in various ways based on the financier. One of the biggest advantages of a loan is that accounts receivable are not sold. A company just gets an advance based on accounts receivable balances. Loans may be unsecured or secured with invoices as collateral. With an accounts receivable loan, a business must repay.

Companies like Fundbox, offer accounts receivable loans and lines of credit based on accounts receivable balances. If approved, Fundbox can advance 100% of an accounts receivable balance. A business must then repay the balance over time, usually with some interest and fees.

Accounts receivable lending companies also benefit from the advantage of system linking. Linking to a companies accounts receivable records through systems such as QuickBooks, Xero, and Freshbooks, can allow for immediate advances against individual invoices or management of line of credit limits overall.

Underwriting

Factoring companies take several elements into consideration when determining whether to onboard a company onto its factoring platform. Furthermore, the terms of each deal and how much is offered in relation to accounts receivable balances will vary.

Accounts receivables owed by large companies or corporations may be more valuable than invoices owed by small companies or individuals. Similarly, newer invoices are usually preferred over older invoices. Typically, the age of receivables will heavily influence the terms of a financing agreement with shorter term receivables leading to better terms and longer term or delinquent receivables potentially leading to lower financing amounts and lower principal to value ratios.

Advantages and Disadvantages

Accounts receivable financing allows companies to get instant access to cash without jumping through hoops or dealing with long waits associated with getting a business loan. When a company uses its accounts receivables for asset sales it does not have to worry about repayment schedules. When a company sells its accounts receivables it also does not have to worry about accounts receivable collections. When a company receives a factoring loan, it may be able to obtain 100% of the value immediately.

Although accounts receivable financing offers a number of diverse advantages, it also can carry a negative connotation. In particular, accounts receivable financing can cost more than financing through traditional lenders, especially for companies perceived to have poor credit. Businesses may lose money from the spread paid for accounts receivables in an asset sale. With a loan structure, the interest expense may be high or may be much more than discounts or default write-offs would amount to.

What Is the Arms Index (TRIN)?

The Arms Index, also called the Short-Term Trading Index (TRIN) is a technical analysis indicator that compares the number of advancing and declining stocks (AD Ratio) to advancing and declining volume (AD volume). It is used to gauge overall market sentiment. Richard W. Arms, Jr. invented it in 1967, and it measures the relationship between market supply and demand. It serves as a predictor of future price movements in the market, primarily on an intraday basis. It does this by generating overbought and oversold levels, which indicate when the index (and the majority of stocks in it) will change direction.

The Formula for Arms Index (TRIN) is:


$\begin{aligned} &\text{TRIN}\ =\ \frac{\text{Advancing Stocks/Declining Stocks}}{\text{Advancing Volume/Declining Volume}}\\ &\textbf{where:}\\ & \begin{aligned} \text{Advancing Stocks}\ =\ &\text{Number of stocks that are higher}\\ &\text{on the day}\end{aligned}\\ &\begin{aligned} \text{Declining Stocks}\ =\ &\text{Number of stocks that are lower}\\ &\text{on the day}\end{aligned}\\ &\begin{aligned} \text{Advancing Volume}\ =\ &\text{Total volume of all advancing}\\ &\text{stocks}\end{aligned}\\ &\begin{aligned}\text{Declining Volume}\ =\ &\text{Total volume of all declining}\\ &\text{stocks}\end{aligned} \end{aligned}$​TRIN = Advancing Volume/Declining VolumeAdvancing Stocks/Declining Stocks​where:Advancing Stocks = ​Number of stocks that are higher​Declining Stocks = ​Number of stocks that are lower​Advancing Volume = ​Total volume of all advancing​​

How to Calculate the Arms Index (TRIN)

TRIN is provided in many charting applications. To calculate by hand, use the following steps.

1. At set intervals, such as every five minutes or daily (or whatever interval is chosen), find the AD Ratio by dividing the number of advancing stocks by the number of declining stocks.
2. Divide total advancing volume by total declining volume to get AD Volume.
3. Divide the AD Ratio by AD Volume.
4. Record the result and plot on a graph.
5. Repeat the calculation at the next chosen time interval.
6. Connect multiple data points to form a graph and see how the TRIN moves over time.

What Does the Arms Index (TRIN) Tell You?

The Arms index seeks to provide a more dynamic explanation of overall movements in the composite value of stock exchanges, such as the NYSE or NASDAQ, by analyzing the strength and breadth of these movements.

An index value of 1.0 indicates that the ratio of AD Volume is equal to the AD Ratio. The market is said to be in a neutral state when the index equals 1.0, since the up volume is evenly distributed over the advancing issues and the down volume is evenly distributed over the declining issues.

Many analysts believe that the Arms Index provides a bullish signal when it’s less than 1.0, since there’s greater volume in the average up stock than the average down stock. In fact, some analysts have found that the long-term equilibrium for the index is below 1.0, potentially confirming that there is a bullish bias to the stock market.

On the other hand, a reading of greater than 1.0 is typically seen as a bearish signal, since there’s greater volume in the average down stock than the average up stock.

The farther away from 1.00 the Arms Index value is, the greater the contrast between buying and selling on that day. A value that exceeds 3.00 indicates an oversold market and that bearish sentiment is too dramatic. This could mean an upward reversal in prices/index is coming.

Conversely, a TRIN value that dips below 0.50 may indicate an overbought market and that bullish sentiment is overheating.

Traders look not only at the value of the indicator but also at how it changes throughout the day. They look for extremes in the index value for signs that the market may soon change directions.

The Difference Between the Arms Index (TRIN) and the Tick Index (TICK)

TRIN compares the number of advancing and declining stocks to the volume in both advancing and declining stocks. The Tick index compares the number of stocks making an uptick to the number of stocks making a downtick. The Tick Index is used to gauge intraday sentiment. The Tick Index does not factor volume, but extreme readings still signal potentially overbought or oversold conditions.

Limitations of Using the Arms Index (TRIN)

The Arms Index has a few mathematical peculiarities that traders and investors should be aware of when using it. Since the index emphasizes volume, inaccuracies arise when there isn’t as much advancing volume in advancing issues as expected. This may not be a typical situation, but it’s a situation that can arise and could potentially make the indicator unreliable.

Here are two examples of instances where problems may occur:

• Suppose that a very bullish day occurs where there are twice as many advancing issues as declining issues and twice as much advancing volume as declining volume. Despite the very bullish trading, the Arms Index would yield only a neutral value of (2/1)/(2/1) = 1.0, suggesting that the index’s reading may not be entirely accurate.
• Suppose that another bullish scenario occurs where there are three times as many advancing issues as declining issues and twice as much advancing volume than declining volume. In this case, the Arms Index would actually yield a bearish (3/1)/(2/1) = 1.5 reading, again suggesting an inaccuracy.

One way to solve this problem would be to separate the two components of the indicator into issues and volume instead of using them in the same equation. For instance, advancing issues divided by declining issues could show one trend, while advancing volume over declining volume could show a separate trend. These ratios are called the advance/decline ratio and upside/downside ratio, respectively. Both of these could be compared to tell the market’s true story.