Financial ratios explained

A ratio is one figure divided by another. It turns two amounts into a single number that stays comparable when the business grows or shrinks. The figures come from the profit and loss statement, which covers a period, and the balance sheet, which describes one date.

That difference decides how a ratio is built. A ratio made only from balance sheet figures uses balances at the same date. A ratio made only from profit and loss figures uses the same period for both. A ratio that mixes the two sets a balance at the end of a period against that period's activity, and some people use the average of the opening and closing balances instead. Whichever you choose, use it every time.

business.gov.au defines liquidity as how quickly assets can be turned into cash. Liquidity ratios compare short-term assets with short-term debts, both taken from the balance sheet at the same date.

• Current ratio: current assets divided by current liabilities. It shows how far the assets that turn into cash within 12 months cover the debts due within 12 months.
• Quick ratio: quick current assets divided by current liabilities. Leave out stock, prepaid expenses and other current assets that are not readily available to meet debts.

The current ratio uses the same totals as working capital, which subtracts current liabilities from current assets instead of dividing. The quick ratio uses a narrower set of assets. Our guide to calculating working capital sets out which balances count as current and how to gather them.

Profitability ratios use the profit and loss statement for one period, with sales or an investment as the figure you divide by.

• Gross margin: gross profit divided by sales. business.gov.au describes gross margin as the proportion of profit in each dollar of sales. It moves with your prices and the direct cost of what you sell.
• Net margin: net profit divided by sales. It shows what is left of each dollar of sales after every expense.
• Return on investment: business.gov.au works it out by dividing the net profit an investment earned by what the investment cost. Use profit for a stated period, and the same length of period each time you compare.

Efficiency ratios set a balance at the end of a period against the activity of that period. They are often turned into a number of days, by multiplying the result by the number of days in the period.

• Debtor days: accounts receivable divided by credit sales for the period, in days. It shows roughly how long customers take to pay, which you can set against the payment terms you offer.
• Stock days: inventory divided by cost of goods sold for the period, in days. It shows roughly how long stock sits before it sells. business.gov.au makes the link to cash plainly: money held in unsold stock isn't available to spend.
• Creditor days: accounts payable divided by purchases on credit for the period, in days. It shows roughly how long the business takes to pay its suppliers.

Together they show the cash cycle. Money is tied up for the time stock waits plus the time customers take to pay, less the time suppliers wait for you.

• Debt to equity: in a common form, total liabilities divided by net assets at the same date. business.gov.au defines net assets as total assets minus total liabilities, also called owner's equity. A higher result means more of the business is funded by what it owes.
• Interest cover: profit before interest divided by the interest expense for the period. It shows how many times over the period's profit could pay the interest.

Lenders use ratios of their own. business.gov.au describes the loan-to-value ratio as the size of a loan set against the market value of the asset it paid for, which a lender uses to judge its chance of getting its money back if the loan isn't repaid.

Cash and receivables at this date fall short of current liabilities, so check when collections, stock sales and payments are expected. The debtor-days estimate is below the creditor-days estimate and stock days is the largest of the three, but these ratios do not establish actual payment timing or show that selling stock is the only way to meet debts. Read them alongside due dates and a cash flow forecast, and compare them with earlier years.

• Work each ratio out the same way every time, from books that are up to date and reconciled.
• Compare it with the same ratio for earlier periods, and with your budget, before drawing a conclusion.
• Look at the figures behind any ratio that moves. A better current ratio can come from a fall in what you owe or a build-up of unsold stock, and those mean very different things.
• Allow for seasons. A balance taken in the busiest month can make a balance sheet ratio look very different from one taken in a quiet month.
• Remember that a ratio summarises. It can't say when a bill falls due or which customer is slow.

business.gov.au suggests reviewing your main financial documents regularly and giving the business a financial health check at least once a year. Tracking a small set of ratios at each review shows the direction of travel. If one moves in a way you can't explain, your accountant can help you find out why.