A ratio on its own says little. A current ratio of 1.50 or a net margin of 8% only becomes useful when you know what question you are asking, how the figure was calculated and what to compare it with. This guide sets out a practical method that works for your own business, a customer or supplier, or a listed company. If you are new to the statements themselves, start with how to read financial statements.
Start from a question, choose the ratios that answer it, calculate them on a consistent basis, compare them over time and with similar businesses, and read them together with the notes.
Start with a question
Decide what you want to know before you calculate anything. The question narrows the ratios you need and tells you which figures matter most. Typical questions include:
- Can the business pay the bills due over the next year?
- How much of each sale turns into profit, and is that changing?
- How much does the business rely on borrowing, and how easily does it cover the interest?
- How quickly does it sell inventory, collect from customers and pay suppliers?
- How does the market price its shares relative to its earnings or book value?
A supplier deciding whether to offer 60 days’ credit and an investor considering a long-term holding will ask different questions of the same accounts, and will usually focus on different ratios.
Pick ratios by category
Ratios fall into five broad groups, each matching one of those questions:
- Liquidity ratios compare short-term assets with short-term obligations.
- Profitability ratios cover margins and returns, such as return on assets and return on equity.
- Leverage ratios compare debt with equity and assets, and earnings with the cost of debt.
- Efficiency ratios measure how quickly inventory, receivables and payables turn over, and how much revenue the assets generate.
- Valuation ratios combine a share price with accounting figures, so they apply only to companies whose shares have a market price.
A few ratios from the relevant group, plus one or two from a related group, are often enough to start. Calculating every ratio available tends to produce more numbers than insight.
Collect figures on a consistent basis
Many errors in ratio analysis come from the inputs rather than the arithmetic.
- Take balance sheet figures from the same date and income statement figures for the same period.
- Match the period of income figures to the days used in day-count ratios, and take care when scaling part-year figures up to a year, especially for a seasonal business.
- Decide whether to use average or ending balances for ratios that mix the two statements, and use the same choice throughout. The guide to average vs ending balances explains the trade-off.
- Check the units and currency, and whether earlier figures have been restated since they were first published.
Compare over time
Comparing the same business across several periods is often the most informative starting point, because its accounting policies and business model usually change less than the differences between two companies.
Look at several periods, not just two, so that one unusual year does not set the story. Then ask what caused each change. A falling gross margin can come from lower prices, higher input costs or a shift in what the business sells. For a seasonal business, compare the same quarter or month end in each year. Watch for breaks in the series, such as an acquisition, a disposal or a change in accounting policy, which can move ratios without any change in the underlying business.
Compare with similar businesses on the same definitions
Comparisons with other businesses only work when they are genuinely similar and the ratios are calculated the same way. What is normal varies by industry and business model. A business that needs heavy equipment tends to hold more assets for each unit of revenue than one that does not, so its asset turnover is often lower for structural reasons. The guide to why financial ratios vary by industry covers this in more detail.
Definitions also differ between sources. Before you compare a ratio from two places, check how each was built:
| Ratio | Where definitions differ |
|---|---|
| Debt-to-equity | Total liabilities or interest-bearing debt only; book or market value of equity |
| Quick ratio | Cash, short-term investments and receivables added up, or inventory subtracted from current assets |
| Inventory turnover | Cost of goods sold or revenue as the numerator |
| Days sales outstanding | Credit sales or total revenue; a 365-day or 360-day year |
| EBITDA margin | EBITDA is not defined by accounting standards, and adjusted figures leave out items the company chooses |
| Return on invested capital | Several definitions of after-tax operating profit and invested capital |
Where sources disagree, this site picks one default and names the alternatives. The methodology page explains how those choices are made.
Read ratios together
Single ratios can mislead. Groups of related ratios explain each other.
DuPont analysis
Return on equity can be split into three factors: net profit margin × asset turnover × equity multiplier, where the equity multiplier is average total assets divided by average shareholders’ equity. Margin shows profitability, turnover shows how much revenue the assets generate and the multiplier shows leverage. If return on equity rises, the split tells you whether the business earned more on each sale, generated more revenue from its assets or financed more of its assets with liabilities. The DuPont analysis calculator shows the three factors side by side.
The liquidity trio
The current ratio, quick ratio and cash ratio apply stricter tests against the same current liabilities. A wide gap between the current and quick ratios shows that much of the cover depends on inventory and other less liquid current assets. A wide gap between the quick and cash ratios shows reliance on collecting receivables. The three together tell you more than any one of them.
Other useful pairs
A rising current ratio looks like more cover, but if inventory turnover is slowing or days sales outstanding is rising at the same time, the increase may be cash tied up in stock and unpaid invoices. The cash conversion cycle brings those day counts together. In the same way, read the debt-to-equity ratio alongside the interest coverage ratio: the first shows how much the business owes relative to equity, the second how many times operating income covers the interest.
Read the notes
The notes to the financial statements explain how the figures were prepared, and they often hold the detail that changes how you read a ratio. Look for:
- Accounting policies, such as how inventory is valued, when revenue is recognized and over how many years assets are depreciated.
- Debt terms: interest rates, repayment dates and any covenants, the conditions lenders attach to the debt.
- Leases, commitments and contingent liabilities, which can affect future cash flows.
- Segment information, which shows whether one part of the business is driving the totals.
- Events after the balance sheet date.
Watch for one-off items and timing
Net income can include items that will not recur, such as a gain on selling a building, a restructuring cost or an impairment charge that writes down an asset. These can move net margin, return on assets and return on equity sharply in one year. Note them, and consider recalculating the ratio without them to see the underlying trend. Be wary, though, when costs described as one-off appear year after year.
Timing around the balance sheet date can also move ratios. Paying suppliers from cash just before year end lowers current assets and current liabilities by the same amount, which raises a current ratio above 1.00 and lowers one below 1.00.
Some ratios stop being meaningful at the edges. Return on equity is not meaningful when shareholders’ equity is negative, and neither is a price-to-earnings ratio when earnings are negative. Treat these cases as a reason to look at other measures, not as numbers to compare.
Putting it together
- Write down the question.
- Choose a few ratios from the matching category.
- Collect figures for several periods on one consistent basis.
- Look at the trend and find out what caused each change.
- Compare with similar businesses only where the definitions match.
- Read related ratios together and check the notes.
- Treat what you find as questions to investigate, not final answers.
The financial ratio analysis example applies this method to an illustrative company, and the guide to the limitations of financial ratio analysis covers what ratios cannot tell you.