Top 5 Accounting Ratios Your Business Needs to Know

ROCE = Earnings Before Interest & Tax (EBIT) / (Capital Employed)

Calculating Earnings Before Interest & Tax (EBIT)

The first number you will need to know is the total Earnings Before Interest & Tax (EBIT). To calculate the EBIT, gather your income statement, and follow this formula:

• Revenue Accounts - Cost of sales = Gross margin
• Gross Margin - Operating expense accounts = EBITDA (Earnings Before Interest, Tax, Depreciation & Amortization)
• EBITDA - Depreciation = EBIT

Calculating Total Assets & Current Liabilities (Capital Employed)

Next, you will calculate the value of your asset accounts. To calculate the Total Assets, gather your balance sheet, and follow this formula:

• Cash Accounts + Accounts Receivable + Inventories = Current Assets
• Current Assets + Fixed Assets = Total Assets

Finally, to calculate your Current Liabilities, follow this formula:

• Accounts Payable + Other Liabilities (Long-term and Short-term) = Current Liabilities 

Finding the ROCE Ratio

The formula for calculating the ROCE ratio is: First, calculate the Total Assets of the company, then subtract Current Liabilities. This will give you the total Capital Employed. Next, divide the EBIT by the Capital Employed.

For example, your company's EBIT equals $77,000, Total Assets are $185,000, and Current Liabilities are $15,000. The equation would look like this: ROCE = $77,000 / ($185,000 - $15,000) To simplify the equation: $77,000 / $170,000 = 0.45 ROCE = 45%  

ROCE ratio incorporates more of a company's financial statements than many other ratios. Because of this, it is particularly useful in companies that are heavily capital-dependent. Investors use this metric often to decide whether to invest in a company.  

Operating Cash Flow Ratio (OCFR)

The Operating Cash Flow ratio is one of several cash flow ratios referred to as a Cash Flow Ratio Analysis. Comparing these ratios can clarify misinterpretations of net income. It is considered a more objective ratio compared to the others. The formula is pretty straightforward compared to some others. 

OCFR = Operating Cash Flow / Current Liabilities

Calculating the Operating Cash Flow

There are two methods for calculating Operating Cash Flow. The first is the Indirect Method, where your T-account uses the accrual method. The second method is the Direct Method, where your T-account uses the cash method. 

Indirect Method from Cash Flow Statement: Net Income + Depreciation - Increase in Accounts Receivable - Decrease in Accounts Payable = Operating Cash Flow

Direct Method from Cash Flow Statement: Net Income - Payroll - Cash to Vendors + Cash from Customers + Interest/Dividends - Income Tax/Interest Paid = Operating Cash Flow

Finally, to calculate your Current Liabilities, follow this formula from your balance sheet:

• Accounts Payable + Other Liabilities (Long-term and Short-term) = Current Liabilities 

Once you have these two numbers, divide the Operating Cash Flow by your Current Liabilities. For example, your company's OCF equals $580,000, and Current Liabilities are $1,135,000. The equation would look like this: OCFR = $580,000 / $1,135,000 = 0.51 or 51% 

Return on Equity (ROE)

This ratio helps business owners and other shareholders understand the Return on Investment (ROI) of the equity (common stock, preferred stock, etc.) they put into the business. It is also commonly referred to as the Return on Net Worth or Return on Net Assets. It can show how productively a company is using its assets to generate a profit. Most companies consider a ratio of 10% to 15% to be the range of success, though it can differ year over year.

ROE = Net Income / Equity

Calculating Net Income

Use an Income Statement to calculate the Net Income using the following formula:

• Revenue Accounts - Cost of Sales = Gross Margin 
• Gross Margin - Operating Expenses - Depreciation = Operating Income/EBIT
• EBIT - Interest - Tax = Net Income

Calculating Shareholder Equity

To find the value of equity accounts, you calculate your Total Assets' value and subtract Current Liabilities. To calculate the Total Assets, gather your balance sheet, and follow this formula:

• Cash Accounts + Accounts Receivable + Inventories = Current Assets
• Current Assets + Fixed Assets = Total Assets

Finally, to calculate your Current Liabilities in your Liability Account, follow this formula:

• Accounts Payable + Other Liabilities = Current Liabilities 

Finding the Return On Equity Ratio

The formula for calculating the ROE ratio is: First, calculate the Total Assets of the company, then subtract Current Liabilities. This will give you the total Equity. Next, divide the Net Income by the Equity.

For example, your company's Net Income equals $62,000, Total Assets are $627,000, and Current Liabilities are $220,000. The equation would look like this: ROE = $62,000 / ($627,000 - $220,000) To simplify the equation: $62,000 / $407,000 = 0.15 ROE = 15%  

Fixed Asset Turnover Ratio

The Fixed Asset Turnover Ratio reflects the revenue generated by investing in fixed assets by your company. If fixed assets are not generating revenue, it may be time to reevaluate how beneficial those assets are in the short-term and long-term. The most important trend to see within this ratio over time is that it steadily rises. 

Fixed Asset Turnover Ratio = Revenue / Fixed Assets

Take the Revenue figure from the Income Statement and the total of the Fixed Asset account from the Balance Sheet. For example, if a company has $657,000 in Revenue and $1,804,000 in Fixed Assets, the Fixed Asset Ratio would be 0.36. This means that for every $1 invested in fixed assets, the Return on Investment would be $0.36. Conversely, if the company has $1,804,000 in Revenue and $657,000 in Fixed Assets, the ROI is $2.75. 

Working Capital Turnover Ratio

Like the Fixed Asset Ratio, the Working Capital Ratio shows the revenue generated by your business's Working Capital. It is often referred to as the Sales Working Capital Ratio, as well. In simple terms, it can be expressed as Current Assets minus Current Liabilities. 

Working Capital Turnover Ratio = Revenue / (Current Assets – Current Liabilities)

Repeating a few of the steps for the ROCE formula, we take the information from the balance sheet to get the Current Assets and Current Liabilities figure. 

• Cash Accounts + Accounts Receivable + Inventories = Current Assets

Next, to calculate your Current Liabilities, follow this formula:

• Accounts Payable + Other Liabilities (Long-term and Short-term) = Current Liabilities
• Current Assets - Current Liabilities = Working Capital

Finally, divide the Revenue figure by the Working Capital to find the ratio. For example, if a company has $233,000 in Revenue and $343,000 in Working Capital, the ratio will be 0.68 or 68%. To clarify, for every $1 invested in Working Capital, there is an ROI of $0.68.

Common Errors in Double-Entry Accounting & How to Fix Them

Running these ratios on a routine basis can help detect anomalies and errors in the general ledger. If the numbers aren't matching up with what the bookkeeper thinks they should be, it may be time to dig deeper to find the cause. Your team should know how to examine the data and look for errors.

Here are some of the most common types of T-account errors and how to fix them.

1. Transposition - This happens when numbers are entered into the general ledger in the wrong order. Instead of '1234', it is entered as '4123'.
2. Entry Reversal - Accidentally switching the debits and credits column when recording business transactions. 
3. Error of Principle - This occurs when a figure is recorded in the wrong account. An example would be putting an asset's value in the expense account as a debit when it should be recorded in the asset account.
4. Subsidiary Entry - These errors are most often caught during reconciliation. Instead of recording a transaction as $100, it is entered as $10. 
5. Rounding Errors - A debit or credit that is entered as a whole number instead of a decimal. Though this might not seem like a big deal, doing this often can lead to large discrepancies over time. 
6. Error of Omission - Omitting a transaction from the general ledger. 
7. Error of Commission - An example of this would be applying a payment to the wrong customer. 

The easiest way to fix errors is to enter a journal entry that reflects the correct details. It is especially helpful to add a note in the journal entry that explains the error that occurred and why. In time, this may help identify the root causes of errors if a pattern is detected. 

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