Finance
Financial Ratio Analysis
Reads a set of accounts through the ratios that matter, liquidity, profitability, efficiency and gearing, to answer the two questions a business owner actually asks: can we afford this, and is the business actually healthy.
Also known as Ratio analysis, Financial health check, Business diagnostic ratios. First set out by No single originator. Ratio analysis is standard management and financial accounting practice, built up through twentieth-century cost and financial accounting and codified into the form taught today by the professional accounting bodies (ICAEW, ACCA, CIMA) and standard finance textbooks. Individual ratios such as the current ratio were already in use by bankers and credit analysts before that; the DuPont system of the 1920s is an early landmark in reading several ratios together rather than one at a time. in 1920; the primary source is cited in full below.
- Format
- Scoring model
- Level
- Corporate · Business unit
- Best for
- Analyse the environment · Assess risk
- Decision stage
- Diagnose · Review
- Difficulty
- Intermediate
- Time to apply
- 30 to 60 minutes once the accounts are to hand
Plate · The model
The components
Liquidity ratios
Whether the business can meet what it owes in the next twelve months from what it can turn into cash in that time. Current ratio and quick ratio (acid-test) are the two standard measures.
Signals of strength
Current ratio below 1:1, current liabilities exceed current assets, a working capital problem in plain terms · Quick ratio materially below the current ratio, a large share of the safety margin sits in stock, which doesn't turn into cash overnight · A current ratio well above 3:1 can be as telling as one too low; cash or stock sitting idle rather than working for the business
Profitability ratios
Whether the trading itself makes money once costs are stripped out at each level: gross margin at the point of sale, operating margin after overheads, ROCE against the capital actually tied up in the business.
Signals of strength
Gross margin drifting down year on year with revenue flat or rising, a pricing or cost-of-sale problem, not a sales problem · Operating margin thin or negative despite a healthy gross margin, overheads have grown faster than the business supporting them · ROCE below the cost of the capital funding the business; the business is working hard just to stand still
Efficiency ratios
How well the business manages the cash tied up in its own working cycle, chiefly how long it actually takes to collect from customers once it has done the work.
Signals of strength
Debtor days rising steadily, a collections problem building well before it shows up as a cash problem · Debtor days running materially longer than the business's own stated payment terms; credit control isn't enforcing what's been agreed · Debtor days close to, or shorter than, creditor days: the business is largely funded by its own customers rather than by its suppliers, a genuinely strong position to be in
Gearing / leverage ratios
How much of the business is funded by debt against the owners' own money, and how exposed it would be if trading slows or interest costs rise.
Signals of strength
Gearing above 100%, more debt than equity, alongside weak interest cover: a business one bad quarter away from a difficult conversation with its bank · Gearing rising sharply year on year without a matching rise in fixed assets or capacity, debt is funding day-to-day trading rather than growth · Very low gearing in a capital-intensive business can signal under-investment as readily as it signals caution
When it earns its keep
- Before signing a lease, taking on debt or making a big capital commitment, to check the business can genuinely carry it
- When a set of year-end accounts has just landed and a glance at the bottom line isn't going to cut it
- When a client, a lender or a business partner is asking how healthy the business really is and want more than a gut feel in reply
- Before extending credit to a customer, or agreeing extended payment terms with a supplier, on the strength of their own numbers
- When comparing this year's figures against last year's, to catch a drift in the business before it turns into a crisis
And when it doesn't
- On a business trading less than a full year, where there isn't yet a clean set of comparable figures to work from
- As a standalone verdict without also looking at the cash position and the order book. Ratios describe the past, not what's coming through the door
- When comparing across genuinely different industries without adjusting for how those industries are financed and stocked
- In the middle of a sharp seasonal trough or peak, without averaging or seasonally adjusting the figures first, or a single month's snapshot will mislead
- As a substitute for reading the actual notes to the accounts, where the real story on debt covenants, provisions and contingent liabilities usually sits
How to run it
Before starting, gather the inputs the analysis depends on:
- A profit and loss account (income statement) for the period, ideally with two to three years to compare
- A balance sheet as at the period end
- Revenue and cost of sales shown separately, not just a single net profit figure
- Trade debtors (receivables) and, where relevant, trade creditors, broken out from the total current asset and liability lines
- Total interest-bearing debt, meaning bank loans and hire purchase or asset finance, not the whole of current liabilities
- Total equity (capital and reserves) from the balance sheet
- Ideally, the same figures for a prior period or a sector comparator, so the ratios have something honest to sit against
- 1
Gather the real numbers
Work from the actual profit and loss account and balance sheet, not a management summary or a one-line P&L. Strip out genuine one-off items (an insurance payout, a bad debt write-off) that would distort a single year's read if left in.
- 2
Calculate the liquidity ratios
Current ratio and quick ratio (acid-test), to see whether short-term bills can actually be paid from what can be turned into cash in the same period.
- 3
Calculate the profitability ratios
Gross margin, operating margin and return on capital employed (ROCE), to see whether trading itself is healthy once costs are stripped out at each level, not just whether the top line is growing.
- 4
Calculate the efficiency ratios
Debtor days, and creditor or stock days where relevant, to see how well the cash tied up in the working cycle is actually being managed.
- 5
Calculate gearing
How much of the business is funded by debt against how much is the owners' own money, and how exposed that leaves the business if interest rates rise or trading slows.
- 6
Compare, don't just calculate
Set every ratio against last year, against a sector benchmark if you have one, and against what the business itself actually needs to survive its next twelve months. A ratio with nothing to sit against is just a number.
- 7
Read the pattern, not the single figure
A strong current ratio sitting next to worsening margins is a different business to one with thin margins and tight control of cash. The combination is the diagnosis; any one ratio on its own rarely is.
Reading the result
A one-page diagnostic: six or seven ratios calculated from the last set of accounts and read together, giving an honest first read on liquidity, profitability, efficiency and how the business is actually funded.
- No single ratio is a verdict on its own. Read liquidity against gearing (a tight current ratio matters far more when gearing is also high) and profitability against efficiency (strong margins can still starve for cash if debtor days are out of control)
- Trend matters more than any one year's figure. Three ratios moving the same direction over two or three years is a pattern worth acting on; one ratio moving alone may just be noise
- Benchmark against the business's own sector wherever possible. A 1.2:1 current ratio is unremarkable in retail and a genuine worry in construction
A worked example
Hartley Groundworks: reading a subcontractor's numbers before the bank meeting
Hartley Groundworks Ltd is a nine-strong civil engineering and groundworks subcontractor working under three regional main contractors around Leicester and Nottingham. Turnover has grown steadily to £2.4 million over three years, largely by winning bigger packages from the same handful of contractors rather than by finding new ones. Dave, the owner, has come in because his bank has asked for updated management accounts before renewing the overdraft, and he wants to know what they're going to see before he walks into that meeting. His year-end accounts show revenue of £2,400,000 and cost of sales of £1,850,000, an operating profit of £115,000, current assets of £480,000 (cash £30,000, trade debtors £380,000, materials and work in progress £70,000) against current liabilities of £410,000, total interest-bearing debt of £340,000 (a bank loan and hire purchase on plant and vehicles), and total equity of £260,000. His standard payment terms are 30 days from invoice.
- Liquidity, current ratio
- £480,000 / £410,000 = 1.17:1. Tight, but not alarming on its own for a subcontractor carrying retentions and stage payments.
- Liquidity, quick ratio
- (£480,000 - £70,000) / £410,000 = 1.00:1. Almost matches the current ratio, because most of the current assets sit in debtors rather than stock, so the liquidity is genuinely there on paper, if the debtors actually pay.
- Profitability, gross margin
- £550,000 / £2,400,000 = 22.9%. In line with typical regional groundworks margins; the trading itself is priced sensibly.
- Profitability, operating margin
- £115,000 / £2,400,000 = 4.8%. Thin, but not unusual for subcontracting, and it leaves very little room for a job that goes wrong.
- Profitability, ROCE
- £115,000 / (£260,000 + £340,000) = 19.2%. A genuinely healthy return on the capital tied up in the business, despite the thin margin. The hard graft is paying off.
- Efficiency, debtor days
- (£380,000 / £2,400,000) x 365 = 58 days, against Dave's own 30-day terms. Nearly double what's actually agreed, and the real story behind the tight current ratio above.
- Gearing
- £340,000 / £260,000 = 130.8%. Geared above 100%, but mostly plant and vehicle hire purchase against machinery the business owns and uses, not distressed working-capital borrowing.
The read. On the numbers alone, Hartley Groundworks isn't in trouble. Current ratio, quick ratio and ROCE all sit in reasonable territory for a groundworks subcontractor, and the gearing is mostly asset finance against kit the business actually owns, not borrowing to cover a hole. But the debtor days are the number I'd want fixed before the bank meeting, not explained away. Fifty-eight days against thirty-day terms means Dave is quietly financing his three main contractors to the tune of the best part of a month's turnover, and that is what's making the current ratio look tighter than the underlying business really is. Growing revenue on top of a collections problem just makes the collections problem bigger. Fix the terms, or enforce the terms already agreed, before chasing the next contract.
Pitfalls
- Ratios are built entirely from historical accounts, sometimes six to nine months old by the time you see them, so they describe where the business has been, not where it's heading
- Different accounting policy choices (stock valuation, depreciation method, when revenue is recognised on long contracts) can move a ratio significantly between two businesses that are actually in similar health
- A set of accounts can be deliberately window-dressed around the year end. A short-term cash injection or a delayed supplier payment run just before the balance sheet date will flatter the current ratio without changing anything real
- Comparing ratios across industries without adjusting for how each is financed and stocked produces a false read; a retailer and a construction subcontractor will have a naturally different 'normal' current ratio
- A single ratio taken in isolation tells you very little. A healthy current ratio sitting alongside collapsing margins is not, in fact, a healthy business
- Ratios describe symptoms rather than causes. A poor quick ratio tells you there's a liquidity problem; it doesn't tell you whether that's a pricing problem, a collections problem or a genuine trading loss, and that question still has to be asked separately
What the critics say
Ratio analysis works from historical accounting data, which makes it well suited to confirming a business is already in difficulty and poorly suited to warning anyone before it gets there.
Atrill, P. and McLaney, E., Financial Management for Decision Makers, Pearson
The ratios are only as reliable as the accounting policies and estimates behind them. Two businesses in genuinely similar underlying health can produce materially different ratios depending on how stock is valued or when revenue on long contracts is recognised.
ICAEW, Business Finance guidance materials
Comparing ratios across industries, or across two businesses in the same industry financed quite differently, without adjusting for that difference is one of the most common misapplications of the technique in practice.
ACCA, 'Ratio analysis' technical article
Work it through
Enter the figures from a set of year-end or management accounts, revenue and cost of sales, current assets and liabilities, debt and equity, and trade debtors, and the core health ratios are calculated for you. Your entries persist for this browser session and can be copied out as Markdown or printed.
Inputs
Result
- Gross margin
- 22.9%
- Operating margin
- 4.8%
- Return on capital employed (ROCE)
- 19.2%
- Current ratio
- 1.2:1
- Quick ratio (acid-test)
- 1:1
- Gearing
- 130.8%
- Debtor days
- 57.8 days
Sources and further reading
- ACCA, 'Ratio analysis', ACCA Global technical articles (Financial Accounting exam resources) ↗
- Atrill, P. and McLaney, E., Financial Management for Decision Makers, 9th edn, Pearson, 2020
- ICAEW, Business Finance guidance: interpreting financial statements and ratio analysis
- CIMA (Chartered Institute of Management Accountants), Management Accounting Official Terminology