Financial ratios that matter: liquidity, profitability, efficiency and leverage

A set of accounts holds hundreds of numbers. Ratios cut them down to a few that answer practical questions. Can the business pay its bills next month? Does it make enough on each pound of sales? Is cash stuck in stock or unpaid invoices? Could it survive a rise in interest rates?

This guide groups the most useful ratios into four families, works through them on one example company, and explains how to read the results without falling into the usual traps. It assumes you can already find revenue, profit and the main balance sheet lines in a set of accounts.

Liquidity: can the business pay its bills?

Liquidity ratios compare what the business can turn into cash soon with what it owes soon.

• Current ratio = current assets divided by current liabilities. Current assets include cash, customer debts (receivables) and stock. Current liabilities are amounts due within a year, such as supplier bills, tax and short-term loans.
• Quick ratio (acid test) = current assets minus stock (and prepayments), divided by current liabilities. It leaves out stock because stock may take months to sell, or may only sell at a discount.
• Cash ratio = cash divided by current liabilities. The strictest test.

A quick ratio of around 1 is often treated as comfortable, meaning liquid assets cover short-term debts, but norms differ widely by industry. A supermarket that collects cash at the till and pays suppliers later can run safely on low ratios. A manufacturer holding months of stock cannot.

Profitability: does the business make money?

• Gross margin = gross profit divided by revenue. Shows how much is left after the direct cost of what you sell.
• Operating margin = operating profit divided by revenue. Shows what is left after overheads as well.
• Net margin = net profit divided by revenue. After interest and tax.
• Return on assets (ROA) = net profit divided by total assets. How much profit the business earns from everything it owns.
• Return on equity (ROE) = net profit divided by shareholders’ equity. The return earned on the owners’ money.

Margins tell you about pricing and cost control. Returns tell you whether the business earns enough on the money tied up in it. A business can have a fine margin and a poor return if it needs a lot of assets to produce its sales.

Efficiency: how hard are the assets working?

Efficiency (or activity) ratios show how quickly the business turns assets into sales and cash.

• Asset turnover = revenue divided by total assets.
• Stock turnover = cost of sales divided by average stock. Stock days = 365 divided by stock turnover.
• Debtor days (average collection period) = receivables divided by credit sales, multiplied by 365.
• Creditor days = payables divided by cost of sales (or purchases), multiplied by 365.

These ratios connect profit to cash. Rising stock days or debtor days mean more cash is tied up, even if profit looks healthy. (The guide to working capital and the cash conversion cycle goes deeper on this.)

Leverage: how much debt, and how safe is it?

• Debt to equity = total borrowings divided by shareholders’ equity.
• Debt ratio = total liabilities divided by total assets.
• Interest cover (times interest earned) = operating profit (EBIT) divided by interest expense. Some lenders use EBITDA instead.

Debt raises returns to owners when things go well and raises risk when they do not, because interest is due regardless. Interest cover below 1 means operating profit does not even cover the interest bill. Lenders often write minimum interest cover and maximum debt levels into loan agreements as covenants, so know where you stand.

A worked example

An example (illustration only): a small homeware wholesaler reports the following for its latest year.

What do these say together? Profitability looks reasonable and debt is comfortably serviced. The weak spot is liquidity: once stock is excluded, liquid assets cover only 80% of short-term debts. Stock days of 68 suggest more than two months of stock on the shelves. The obvious question for management is whether some of that stock is slow-moving, because releasing it would improve both the quick ratio and the cash position. (For simplicity the example uses year-end stock rather than an average, and treats all sales as credit sales.)

How to use ratios well

1. Pick the eight to ten ratios that matter for your type of business rather than calculating everything.
2. Calculate them the same way every time, and write down your definitions.
3. Compare over time. A trend across three to five years tells you more than one year in isolation.
4. Compare with peers in the same industry, using sector data or competitors’ filed accounts where available.
5. Read the ratios together. A falling margin with rising asset turnover can be a deliberate strategy of lower prices and higher volume.
6. Ask why. Every unusual ratio is a question to put to whoever runs that part of the business.

Common mistakes and limits

• Comparing across industries. A software company and a builders’ merchant will never have similar ratios, and neither is wrong.
• Ignoring accounting differences. Companies may treat depreciation, stock valuation or leases differently, so ratios may not compare directly.
• Reading year-end figures as typical. Seasonal businesses can look very different at their year end than in their busy season.
• Mixing definitions, such as using net profit in one year and operating profit in another.
• Treating a rule of thumb as a target. A current ratio of 2 is not automatically healthy if it comes from unsellable stock.

Ratios are a starting point for questions, not a verdict. Used consistently, they let you spot problems early and explain your business clearly to lenders, investors and your own team.