How to understand financial ratios

How-to

Financial ratios are a way to analyse and evaluate the financial health and performance of a business.

They are calculated using information from your business’ financial statements, such as your balance sheet, income statement and statement of cash flows.

By analysing financial ratios, a business owner can get a better understanding of their business’ strengths and weaknesses, and identify areas for improvement.

There are many different financial ratios that can be calculated, and each one provides a different perspective on the financial health of a business.

Common financial ratios

Here are some examples of commonly used financial ratios, along with an explanation of how to calculate and interpret them.


Liquidity ratios

These ratios measure a business’s ability to pay its short-term debts and obligations. Examples include the current ratio and the quick ratio.

Current ratio

The current ratio is calculated by dividing a business’ current assets by its current liabilities.

A current ratio of 1.0 or higher is generally considered to be healthy, indicating that the business has enough assets to cover its short-term debts.

Current ratio formula

Quick ratio

The quick ratio, also known as the acid test, is similar to the current ratio, but it excludes inventory from the calculation. This is because inventory can be difficult to quickly convert into cash.

A quick ratio of 1.0 or higher indicates that a business has enough liquid assets to cover its short-term debts.

Quick ratio formula


Debt ratios

These ratios measure a business’ debt burden and its ability to pay back its loans. Examples include the debt-to-equity ratio and the debt-to-asset ratio.

Debt-to-equity ratio

The debt-to-equity ratio is calculated by dividing a business’ total debt by its shareholder equity. A high debt-to-equity ratio may indicate that a business is relying heavily on borrowing to finance its operations, which can be risky if the business is unable to generate enough profits to pay back its debts.

Debt to equity ratio formula

Debt-to-asset ratio

The debt-to-asset ratio is calculated by dividing a business’ total debt by its total assets. A high debt-to-asset ratio may indicate that a business has taken on too much debt relative to the value of its assets, which could make it difficult for the business to meet its financial obligations.

Debt to asset ratio formula


Profitability ratios

These ratios measure a business’ ability to generate profits and return on investment. Examples include the gross profit margin, net profit margin, and return on equity.


Gross profit margin

The gross profit margin is calculated by dividing the business’ gross profit (revenue minus cost of goods sold) by its total revenue. A high gross profit margin indicates that a company is able to sell its products or services at a relatively high price, or that it has a low cost of goods sold.

Gross profit margin formula


Net profit margin

The net profit margin is calculated by dividing a business’s net profit (total revenue minus all expenses) by its total revenue. A high net profit margin indicates that a business is able to generate a lot of profits from its sales.

Net profit margin formula

Return on equity

The return on equity is calculated by dividing a business’ net income by its shareholder equity.
A high return on equity indicates that a business is generating a good return on the investment made by its shareholders.

Return on equity formula

How to use financial ratios to improve your business

There are a few steps that businesses can take to take advantage of the information that you can gain from understanding financial ratios.

Gather financial information

The first step is to gather the necessary financial information, including balance sheets, income statements, and statement of cash flows. This information is typically available in a business’ financial statements, which are usually prepared by an accountant or financial professional.


Calculate financial ratios

Once you have the necessary financial information, you can begin calculating financial ratios using the formulas provided in the previous response.

It’s a good idea to calculate a variety of ratios, as each one provides a different perspective on the financial health of the business.

Analyse and interpret the results

Once you have calculated the financial ratios, the next step is to analyse and interpret the results. This involves comparing the ratios to industry benchmarks, as well as to the business’ own historical performance. By analysing the results, you can get a better understanding of the business’ strengths and weaknesses, and identify areas for improvement.

Use the results to make informed business decisions

The final step is to use the results of the financial ratio analysis to make informed business decisions. This may involve taking actions to improve the business’ financial performance, such as reducing expenses, increasing sales, or seeking additional funding.

The takeaway

Good businesses use financial ratio analysis to get a better understanding of their financial health and make informed decisions to improve their performance.

These are just a few examples of the many financial ratios that can be calculated.

By regularly analysing financial ratios, you will get a better understanding of the financial health of your business and be able to identify areas for improvement.

The better you understand the current footing of your business — the more able you are to make the right calls when it comes to forecasting and planning your finance needs. It’s also a great trigger to ensure that you’re making the most of your existing assets.

If you’d like to make the most of your working capital, our team can offer a free assessment. Simply book a consultation and we can show you what options you could be using to help you reach your goals.

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