Financial ratios

What it means

Financial ratios are figures obtained by dividing two items from the balance sheet or income statement. They are the core tool of financial analysis because they turn absolute amounts into comparable proportions, making it possible to compare a small and a large company or two different years.

They are traditionally grouped into four families. Liquidity ratios measure the ability to pay short-term debts, leverage ratios the share of borrowed funds, profitability ratios the return on capital and sales, and activity ratios how fast inventory, receivables and payables turn over.

A single figure says little on its own. It gains meaning only by comparison: with the company’s previous periods, with the plan, or with similar firms in the industry through benchmarking. A current ratio of 1.2 may be fine for a retailer and a warning sign for a manufacturer.

How it works in practice

After the year-end close, we give clients a short overview of a few key ratios over the last three years. Instead of dozens of numbers, we pick those that genuinely say something for that type of business and add one sentence explaining what each change means.

Banks lending to a company watch mainly leverage, interest cover and the ability to repay debt from operating cash flow, often writing them into the loan agreement as covenants. It is worth calculating them continuously so the company knows in advance when it is nearing a breach.

For a deeper look at profitability we use DuPont analysis, which breaks return on equity down into margin, asset turnover and financial leverage. Management can then see whether a weaker result came from pricing, underused assets or the financing structure.

What to watch out for

Ratios are only as good as the accounting data beneath them. If the company does not handle accruals, provisions or inventory correctly, the ratios will be distorted and can lead to wrong decisions.

Beware of seasonality and one-off events too. A ratio based on the 31 December balance sheet may not reflect the usual position during the year, and a single large asset sale can boost profitability markedly without the underlying business improving.