Financial ratios, and what they miss

Raw figures from two companies of different sizes cannot be compared. Divide each line by another line from the same accounts and they can be. A ratio strips out scale and leaves the relationship behind, which is the whole point.

One condition comes with it: the two lines must be measured on a basis that makes their division mean something.

• A [balance sheet](/definitions/balance-sheet) line is a photograph taken on one date: cash, inventory, debt and equity as they stood.
• An income statement line covers a stretch of time: revenue, cost of goods sold and profit, totalled over a quarter or a year.

Divide two balance sheet lines and the result is a position on that date. Divide two income statement lines from the same period and both sides cover the same stretch of time, which is what a margin does and what interest cover does. Divide an income statement line by a balance sheet line, which every turnover and return ratio does, and you are dividing a flow by a snapshot. The convention there is to average the opening and closing balance, because a year of sales was not produced by the assets held on its last afternoon. The worked examples below have one balance sheet to hand rather than two, so they use the closing figure and read as though it held all year.

Four families cover almost everything that can be built from the accounts alone:

One well-known group is missing on purpose. Valuation ratios, price-to-earnings and enterprise value to EBITDA among them, divide an accounting line by a market price, so they measure what buyers of the shares currently think as much as what the business did. They belong next to the share price rather than in the four families here, though the rule about comparables applies to them just as hard.

The four families are not rivals. They ask four questions about one company, and an answer from one usually explains an answer from another.

A liquidity ratio asks whether what the company already holds covers what already falls due. Read the second half of that carefully: current liabilities are the obligations sitting on the books at the balance sheet date, not everything the next twelve months will cost, and the window is a year or the operating cycle where that runs longer.

The current ratio divides current assets by current liabilities. The quick ratio repeats the division with inventory removed, on the grounds that stock has to be sold to somebody before it becomes cash. Some analysts strip prepayments out as well, which lowers it again, so it is worth knowing which version a published figure used. The cash ratio is harsher still and counts only cash and short-term investments. Northgate Supply, the distributor in the worked examples below, holds $600,000 of current assets against $400,000 of current liabilities, so its current ratio is 1.50. Take out its $200,000 of inventory and the quick ratio is 1.00.

The same comparison written as a subtraction rather than a division is working capital, $200,000 here. The ratio travels better between companies of different sizes, which is why the ratio is the one that gets quoted.

Then the part that gets skipped. A liquidity ratio compares two piles without asking how fast either one moves. A grocery chain can run a quick ratio near 0.50 for years without a cash problem: it sells stock in days, takes payment at the till, and settles with suppliers weeks later. A machine tool dealer showing the same 0.50, on stock that turns over once a year and customers who pay in ninety days, is in a different position entirely. The ratio cannot tell the two apart, because nothing in it measures time.

That is why liquidity ratios belong next to turnover ratios rather than on their own, and why the guide to what liquidity means starts from speed rather than from size. The current and quick ratio calculator works both readings from one set of accounts.

Leverage ratios measure how much of the business was paid for with money that is not the owners'. Debt-to-equity divides debt by equity. Debt-to-assets divides the same debt by total assets, so it reads as a share of the whole. The equity multiplier divides total assets by equity, and it is the one that tells you what a bad year does.

Which debt line goes on top changes all three before any arithmetic starts. This page uses total liabilities throughout, so equity is assets minus everything owed, and on that reading debt-to-equity plus 1 is always the equity multiplier. A page that counted interest-bearing borrowings only would print smaller figures off the same balance sheet, and the two are not comparable.

Northgate holds $1,000,000 of total assets against $600,000 of liabilities, which is the $400,000 of current liabilities from the section above plus $200,000 of longer-term borrowing. Its equity is therefore $400,000 and its equity multiplier is 2.50. Ridgeway Trading runs the same trade on the same $1,000,000 of assets owing $200,000 in total, so its equity is $800,000 and its multiplier is 1.25.

Debt is a fixed claim. It does not shrink because the assets behind it lost value, so the whole of the loss lands on equity. In dollars the two falls are the same size. As percentages they are not, because the equity they are measured against is the smaller number, and the multiplier is exactly that gap:

$$\text{percent fall in equity} = \text{percent fall in assets} \times \frac{A}{E}$$

A 10 percent fall in asset values takes 25 percent of Northgate's equity and 12.5 percent of Ridgeway's. Identical assets, identical shock, exactly double the proportional damage, and the multiplier said so in advance. The same arithmetic runs upward in a good year, which is why the ratio is a measure of sensitivity rather than a verdict.

A fourth ratio asks whether the interest can be paid at all. Interest cover divides operating profit by the interest bill, and some lenders put EBITDA on the top line instead, which flatters the same company because the depreciation is added back. A company at 1.5 times cover has far less room than one at 8 times, whatever their debt-to-equity ratios say. This is also the one reading on the page that carries meaning with no comparable at all: below 1, the profit did not cover the interest.

One definitional choice is left. Book equity and the market value of the shares are different numbers, often by a wide margin, and a company trading well above its book value looks far less borrowed on the market measure. The leverage ratio calculator at the top of this page works all three ratios from one balance sheet, on the total liabilities reading.

Profitability ratios ask what share of something turns into profit, and they arrive as a ladder. Gross margin is gross profit over revenue, and Northgate's is 30 percent. Operating margin subtracts wages, rent and marketing. Net margin subtracts interest and tax as well, and Northgate's is 4 percent. The 26 points between the two are everything that is not the goods: the running costs first, then the interest and the tax, which is why net margin is partly a statement about the balance sheet rather than about trading.

Efficiency ratios ask how hard the assets work. Inventory turnover divides cost of goods sold by inventory: $1,400,000 of cost against $200,000 of stock is 7.0 turns a year, or about 52 days of stock on hand. Asset turnover divides revenue by total assets, so Northgate's $2,000,000 of sales on $1,000,000 of assets is 2.00. Both use the closing balance here because one balance sheet is all there is; given an opening figure too, the average is the better denominator.

Return on equity ties all three families together:

$$\text{ROE} = \frac{\text{net profit}}{\text{revenue}} \times \frac{\text{revenue}}{\text{assets}} \times \frac{\text{assets}}{\text{equity}}$$

Revenue cancels, assets cancel, and net profit over equity is what is left, so this is an identity rather than a model, provided the same revenue, asset and equity figures are used in every term. It is return on equity written as net margin, times asset turnover, times the equity multiplier. Northgate's 4 percent, 2.00 and 2.50 multiply to 20 percent. Ridgeway, trading identically on less debt, has a multiplier of 1.25 and a return on equity of 10 percent.

Two things stop that being an argument for borrowing. Holding the net margin equal across the two flatters Northgate, because it pays more interest, so in practice its net margin would be the lower of the pair and the gap narrower than double. And the multiplier lifts return on equity only while the assets earn more than the debt costs; below that line the same 2.50 pulls the return down instead of up. What the split buys you is the ability to say where a return came from, which is the only way to tell a better business from a bigger loan.

Interest cover aside, no ratio on this page has a right answer on its own. The remembered thresholds, a current ratio above 2, a quick ratio above 1, debt-to-equity below 1, misrank real businesses often enough that a reading on either side of them settles nothing. Large grocers routinely fail all three at once, and for one reason: they sell stock in days and pay their suppliers on far longer terms, so a balance sheet that looks thin is the business model working.

A ratio becomes information when it is set against one of two things.

The same company over time. A current ratio that has slid from 1.80 to 1.10 across four quarters says something no single reading can. This is the stronger comparison, because the accounting policies, the business mix and the definition of every line are held roughly constant. Watch the base: a ratio that jumped because last year's denominator was unusually small has not improved.

A company doing the same work. Peers share an operating model, so the same forces shape their ratios. Match the accounting before you compare: the debt line, the fiscal year end, the inventory method, and whether the figures are consolidated. A median across a group of peers beats a single rival, which may be the outlier itself.

What does not compare is a ratio against a different industry. Software firms carry almost no inventory, so their quick and current ratios are nearly the same number. Regulated utilities commonly run debt-to-equity at or above 1.0, which their regulators allow them against predictable cash flows and long-lived assets. Neither fact is a grade.

One more comparable is worth building: the cost structure behind the margin. How much fixed cost sits below the gross profit line decides how much volume that margin has to cover, which is what the break-even calculator works out.

Every ratio here is a ratio of accounting figures, which sets a hard limit on what it can see.

A balance sheet ratio is measured on one date, known well in advance. Northgate's current ratio is 1.50. If it uses $200,000 of cash to settle $200,000 of supplier invoices on the last day of the year, current assets fall to $400,000 and current liabilities to $200,000, and the current ratio prints 2.00. Nothing about the trading changed, and within weeks the payables have built back up. Subtracting the same amount from both sides of a division pushes any ratio already above 1 further above it, which is why a current ratio that improves only at the year end deserves a look. Selling receivables, delaying purchases and pulling shipments forward do the same job on other lines.

Accounting policy moves the ratio without moving the business. In the United States, accounting rules let a company value inventory on a last-in-first-out basis, which the international standards used across most of the rest of the world do not permit. While prices are moving, two identical warehouses can therefore report different inventory, cost of goods sold and margins. Revenue recognition timing, depreciation lives and lease accounting all do the same job, and those are not confined to one country.

The accounts do not record everything that matters. A customer worth 40 percent of revenue and about to leave, a brand built rather than bought, a lawsuit at an early stage, a founder resigning: none of these has a line. Ratios are backward-looking by construction and published weeks or months after the period they describe, depending on the market the company reports into and how big it is.

None of this makes ratios useless. It makes them a set of questions rather than a set of answers. A ratio that looks wrong is a reason to read the notes and the cash flow statement, which is usually where the explanation sits.