Ratios turn financial statements into figures you can compare across periods and businesses. Every ratio inherits the limits of the numbers it is built from, though, and adds some of its own. Knowing those limits helps you read a ratio as a starting point for questions rather than as a verdict.
Accounting choices and estimates
Accounting standards leave room for choice. A business decides how to assign costs to inventory, how to depreciate its equipment and over how many years, and, within the rules, when to recognize some revenue and costs. Two businesses with identical transactions can report different profits and asset totals as a result.
Many figures also rest on estimates. Management estimates how much of its receivables will not be collected, whether stock has lost value, how long assets will last and what warranty claims will cost. When an estimate changes, profit and asset values change with it, and so do the ratios built on them, even though no cash has moved. The notes to the financial statements set out the main policies and estimates; how to read financial statements explains where to find them.
Book values are not market values
Most assets are recorded at what they cost, less depreciation, not at what they are worth today. Land bought decades ago may sit on the balance sheet far below its current value. Resources a business builds itself, such as a brand or a customer base, usually do not appear at all. When one business buys another, though, it records intangible assets and goodwill for what it acquired. Two similar businesses can therefore show very different asset totals depending on whether they grew by acquisition or on their own.
This affects every ratio that uses book assets or book equity, including return on assets, return on equity and debt-to-equity. A business with a small book value of equity can show a very high return on equity, and one whose equity has turned negative after losses or large payouts to shareholders has no meaningful return on equity at all. The price-to-book ratio compares market value with book value directly.
One-off items
A single period’s profit can include gains or losses that will not recur: a profit on selling a building, restructuring costs, an impairment, or a legal settlement. These move net profit margin, return on equity and earnings per share without any change in day-to-day trading. Look at several years of figures and read what net income includes.
Take care with “adjusted” profit measures that strip such items out. Companies choose their own adjustments, so one company’s adjusted figure may not be comparable with another’s. EBITDA itself is not defined by US GAAP or IFRS, and a figure with further adjustments should be called adjusted EBITDA.
Seasonality and single-date balance sheets
A balance sheet shows one date. For a seasonal business, inventory, receivables and borrowing can be much higher at the peak than at the year end, so ratios based on year-end balances may not represent the rest of the year. Some businesses end their financial year at a quiet point in their trading cycle, when stock and receivables are low, which widens the gap.
Ratios that set a full period of income against a balance on one date are affected most. Averaging the opening and closing balances helps, and averaging quarterly balances helps more; the guide to average vs ending balances explains how. Also keep periods consistent: a ratio based on one quarter’s income is not comparable with one based on a full year.
Definitions differ between sources
Many ratios have more than one accepted definition, and textbooks, data providers and lenders do not always agree. The same company can show different values for the same named ratio depending on where you look. Common differences include:
| Measure | Where definitions differ |
|---|---|
| Debt-to-equity | Total liabilities or interest-bearing debt only; book value or market value of equity |
| Quick ratio | Cash, short-term investments and receivables added up, or inventory subtracted from current assets, which keeps prepaid expenses in |
| Return on assets and return on equity | Average balances or a single year-end balance |
| Inventory turnover | Cost of goods sold or revenue divided by inventory |
| Day-count measures | A 365-day or 360-day year; for days inventory outstanding, ending or average inventory |
| EBITDA | Built up from net income or from operating income; with or without company-specific adjustments |
| Return on invested capital | Whether invested capital subtracts cash or includes leases; which tax rate is applied |
| Earnings per share | Whether preferred dividends are deducted; weighted average shares for the period or shares at one date; basic or diluted |
| Debt service coverage | Net operating income for property loans or EBITDA for an operating business; each lender sets its own terms |
These versions answer slightly different questions. What matters is knowing which one a figure uses and comparing only figures built the same way. The ratio pages on this site state which definition each calculator uses, and the methodology explains how the defaults are chosen.
Inflation and currency
Because assets stay at historical cost, inflation widens the gap between book values and current prices over time. A business with older assets bought at lower prices shows a smaller asset base, and often a higher return on assets, than a similar business that bought the same assets recently. When prices are rising, the inventory cost method matters more too, because it decides whether older, lower costs or newer, higher costs flow into cost of goods sold. Inflation also affects trends: revenue can grow partly because prices rose, not because the business sold more.
Ratios themselves have no currency unit, but exchange rates can still move them. A group with foreign operations usually translates those operations’ balance sheets at the exchange rate on the balance sheet date and their income statements at average rates for the period. A change in exchange rates can then shift ratios that mix the two, even when nothing changed in the local business. When you compare amounts rather than ratios across countries, convert them on a consistent basis first.
Window dressing
Because a balance sheet captures a single date, a business can take steps just before that date that change how its ratios look. Some are ordinary cash management; others can mislead. Examples include paying suppliers early, delaying purchases, pushing extra sales into the period, or repaying a short-term loan and borrowing again after the period end.
A small example shows the effect. A business with current assets of 300,000 and current liabilities of 200,000 has a current ratio of 1.50. If it uses 100,000 of cash to pay suppliers the day before the year end, current assets fall to 200,000 and current liabilities to 100,000, so the ratio becomes 2.00. Working capital is 100,000 before and after, so its net short-term position has not changed. Comparing year-end figures with interim figures can show whether year-end balances are typical.
No universal benchmarks
Rules of thumb about what a ratio should be circulate widely, but no single value suits every business. What is normal depends on the business model, the accounting choices and the economic conditions of the period, as the guide to why financial ratios vary by industry explains. Published industry averages are useful only if you know which businesses they include, how each ratio was defined and whether the figure is a mean or a median.
Ratios can also become extreme when the denominator is very small. A business with almost no equity can show a huge return on equity, and a company with tiny earnings a huge price-to-earnings ratio. When the denominator turns negative, many ratios stop being meaningful at all.
Ratios raise questions, not answers
A ratio tells you that something is different, not why. A change can come from the numerator, the denominator or both: return on assets can rise because profit grew or because assets were sold or written down. Ratios also look backward, describing a period that has already ended. To use them well:
Company A has a current ratio of 2.00 and a quick ratio of 1.80; Company B has a current ratio of 2.00 and a quick ratio of 0.40. Company B can only meet its short-term bills once its inventory sells, which a single ratio does not show.
- Look at the trend over several periods rather than a single figure.
- Check which part of the ratio moved, and why.
- Read related ratios together, since one ratio rarely explains itself.
- Compare with similar businesses whose figures use the same definitions.
- Go back to the statements, the notes and the cash flow statement to test what the ratios suggest.
The guide on how to analyze financial ratios puts these steps together.