Key takeaways
- Liquidity ratios show whether you can pay bills due in the next year; debt ratios show how much of the business is borrowed.
- Profitability ratios show how much of each sale and each dollar of assets turns into profit.
- Efficiency ratios show how fast stock sells and customers pay, which drives cash flow.
- No ratio has one healthy value: compare with your own past years and with businesses in your industry.
Where the numbers come from
Every ratio below uses figures from two reports. The balance sheet shows what the business owns (assets), what it owes (liabilities) and what is left for the owners (equity) on a single date. The income statement, also called the profit and loss statement, shows revenue, costs and profit over a period such as a year.
Current assets are things that will turn into cash within about a year: cash, money customers owe you (accounts receivable) and inventory. Current liabilities are bills due within a year, such as supplier invoices, short-term loans and taxes owed.
Use figures for matching periods. If the balance sheet is dated December 31, use income statement figures for the 12 months to December 31. Ratios built from mismatched dates can mislead.
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The example business
All 12 ratios below are worked out for the same made-up business: a small home goods wholesaler at the end of its financial year. The figures are invented to show the arithmetic, not to suggest what is normal.
| Item | Amount | Source |
|---|---|---|
| Cash | $25,000 | Balance sheet |
| Accounts receivable | $50,000 | Balance sheet |
| Inventory (closing) | $45,000 | Balance sheet |
| Current assets | $120,000 | Balance sheet |
| Total assets | $300,000 | Balance sheet |
| Current liabilities | $80,000 | Balance sheet |
| Total liabilities | $150,000 | Balance sheet |
| Equity | $150,000 | Balance sheet |
| Revenue | $600,000 | Income statement |
| Cost of goods sold | $360,000 | Income statement |
| Gross profit | $240,000 | Income statement |
| Operating income | $54,000 | Income statement |
| Interest expense | $9,000 | Income statement |
| Net profit | $36,000 | Income statement |
| Average inventory (opening $35,000, closing $45,000) | $40,000 | Both |
Liquidity ratios 1–2: can you pay this year’s bills?
1. Current ratio compares current assets with current liabilities. The example business has $120,000 ÷ $80,000 = 1.5, so it has $1.50 of short-term assets for every $1 of short-term bills. Below 1 is a warning sign for most small businesses.
2. Quick ratio is the same test without inventory, because stock cannot pay a supplier until it sells. ($120,000 − $45,000) ÷ $80,000 = 0.94. This business relies partly on selling stock to meet its bills, which is normal for a wholesaler but worth watching.
A stricter version, the cash ratio, counts only cash: $25,000 ÷ $80,000 = 0.31. Lenders sometimes look at it, but few healthy small businesses keep enough cash for it to be near 1.
Current ratio = Current assets ÷ Current liabilities Quick ratio = (Current assets − Inventory) ÷ Current liabilities
Debt ratios 3–5: how much is borrowed, and can you service it?
3. Debt-to-equity compares total liabilities with equity. $150,000 ÷ $150,000 = 1.0, so creditors and owners fund the business equally. The SEC’s guide to financial statements uses this same definition.
4. Debt ratio is the share of assets paid for with liabilities: $150,000 ÷ $300,000 = 50%.
5. Interest coverage shows how many times operating income covers interest payments: $54,000 ÷ $9,000 = 6.0. The lower it gets, the less room there is for a bad year before loan payments become a problem.
Capital-heavy businesses such as manufacturing, property and transport usually carry more debt than service businesses, so compare with your own industry.
Debt-to-equity = Total liabilities ÷ Equity Debt ratio = Total liabilities ÷ Total assets × 100 Interest coverage = Operating income ÷ Interest expense
Profitability ratios 6–10: how well do sales turn into profit?
6. Gross margin is what is left of each sale after the direct cost of the goods: $240,000 ÷ $600,000 = 40%.
7. Operating margin is what is left after running costs such as wages, rent and marketing, but before interest and tax: $54,000 ÷ $600,000 = 9%.
8. Net margin is what is left after every cost: $36,000 ÷ $600,000 = 6%. The gap between gross and net margin shows how much overheads, interest and tax take.
9. Return on assets (ROA) compares profit with everything the business owns: $36,000 ÷ $300,000 = 12%.
10. Return on equity (ROE) compares profit with the owners’ stake: $36,000 ÷ $150,000 = 24%. ROE is higher than ROA here because half the assets are funded with debt. Borrowing raises ROE when things go well and hurts it when they do not.
Some analysts use average assets and equity over the year instead of closing figures. Either is fine as long as you are consistent from year to year.
Gross margin = Gross profit ÷ Revenue × 100 Operating margin = Operating income ÷ Revenue × 100 Net margin = Net profit ÷ Revenue × 100 Return on assets = Net profit ÷ Total assets × 100 Return on equity = Net profit ÷ Equity × 100
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Efficiency ratios 11–12: how fast does cash come back?
11. Inventory turnover shows how many times you sell through your average stock in a year: $360,000 ÷ $40,000 = 9. Divide 365 by 9 and stock sits for about 41 days on average before it sells.
12. Days sales outstanding (DSO) shows how long customers take to pay: $50,000 ÷ $600,000 × 365 = about 30 days. If your terms are 30 days, customers are paying roughly on time. If DSO climbs well past your terms, chase invoices sooner.
Together these tell you how long cash is tied up. Here, money spent on stock takes about 41 days to sell and another 30 days to collect, around 71 days in all, before you count the time you take to pay suppliers.
Inventory turnover = Cost of goods sold ÷ Average inventory Days sales outstanding = Accounts receivable ÷ Revenue × 365
Free toolInventory turnover calculatorAll 12 at a glance, and how to use them
A ratio on its own says little. A current ratio of 1.5 is comfortable for one business and tight for another. The most useful comparisons are with your own figures over several years, to see the direction of travel, and with businesses of a similar type and size. Trade associations, banks and accountants can often provide industry averages.
Look at the ratios together. Rising sales with a falling quick ratio and rising DSO can mean growth is being funded by unpaid invoices. A strong net margin with weak interest coverage may mean a loan that is too large for the business.
| # | Ratio | Result | Group |
|---|---|---|---|
| 1 | Current ratio | 1.5 | Liquidity |
| 2 | Quick ratio | 0.94 | Liquidity |
| 3 | Debt-to-equity | 1.0 | Debt |
| 4 | Debt ratio | 50% | Debt |
| 5 | Interest coverage | 6.0x | Debt |
| 6 | Gross margin | 40% | Profitability |
| 7 | Operating margin | 9% | Profitability |
| 8 | Net margin | 6% | Profitability |
| 9 | Return on assets | 12% | Profitability |
| 10 | Return on equity | 24% | Profitability |
| 11 | Inventory turnover | 9 times (about 41 days) | Efficiency |
| 12 | Days sales outstanding | About 30 days | Efficiency |
