Financial Ratios: Key Metrics for Evaluating Business Performance

Financial ratios are like a business owner's dashboard—quick, clear, and essential for making smart decisions. They transform complex financial data into simple, actionable insights, helping owners gauge profitability, efficiency, and overall financial health at a glance.

Whether it's tracking margins to pinpoint cost-saving opportunities, assessing return on assets to maximise investments, or monitoring liquidity to ensure smooth operations, these ratios act as a financial compass.

They also provide a competitive edge by revealing strengths, weaknesses, and trends that might otherwise go unnoticed.

In short, financial ratios take the guesswork out of business growth, allowing owners to make informed, confident choices that drive success.

Liquidity Ratios

Liquidity ratios measure a company's ability to meet short-term financial obligations.

Current Ratio

Formula: Current Assets / Current Liabilities

Purpose: Measures a company’s ability to cover short-term obligations. A ratio above 1 indicates good liquidity.

Example: If a company has £500,000 in current assets and £250,000 in current liabilities, the current ratio is 2.0, indicating strong liquidity.

Quick Ratio (Acid-Test Ratio)

Formula: (Current Assets - Inventory) / Current Liabilities

Purpose: A stricter measure of liquidity that excludes inventory from assets.

Example: If a company has £500,000 in current assets, £150,000 in inventory, and £250,000 in current liabilities, the quick ratio is 1.4, showing decent liquidity.

Leverage Ratios

Leverage ratios assess a company’s reliance on debt financing.

Debt-to-Equity Ratio

Formula: Total Debt / Total Equity

Purpose: Assesses a company’s financial leverage. A higher ratio indicates more reliance on debt.

Example: If total debt is £300,000 and total equity is £600,000, the ratio is 0.5, meaning the company uses half as much debt as equity.

Interest Coverage Ratio

Formula: EBIT / Interest Expense

Purpose: Measures how easily a company can cover interest expenses. A higher ratio indicates better financial health.

Example: If EBIT is £200,000 and interest expense is £40,000, the ratio is 5, meaning the company earns five times its interest obligations.

Profitability Ratios

Profitability ratios evaluate a company's ability to generate profit.

Gross Profit Margin

Formula: (Revenue - Cost of Goods Sold) / Revenue × 100

Purpose: Shows profitability before operating expenses.

Example: If revenue is £1,000,000 and COGS is £600,000, the margin is 40%.

Operating Profit Margin

Formula: Operating Profit / Revenue × 100

Purpose: Reflects core operational profitability before taxes and interest.

Example: If operating profit is £150,000 and revenue is £1,000,000, the margin is 15%.

Net Profit Margin

Formula: Net Profit / Revenue × 100

Purpose: The percentage of revenue retained as profit after all expenses.

Example: If net profit is £100,000 and revenue is £1,000,000, the margin is 10%.

Return on Assets (ROA)

Formula: Net Profit / Total Assets × 100

Purpose: Measures how efficiently assets generate profit.

Example: If net profit is £100,000 and total assets are £1,000,000, ROA is 10%.

Return on Equity (ROE)

Formula: Net Profit / Shareholder’s Equity × 100

Purpose: Shows return on investment for shareholders.

Example: If net profit is £100,000 and equity is £500,000, ROE is 20%.

Gross Margin

Formula: (Net Sales − Cost of Goods Sold (COGS)) / Net Sales ×100

Purpose: Shows the percentage of revenue that exceeds COGS.

Example: If net sales are £800,000 and COGS is £400,000, the gross margin is 50%.

Operating Margin

Formula: (Operating Income / Net Sales) × 100

Purpose: Reflects the percentage of revenue retained after operating expenses.

Example: If operating income is £100,000 and net sales are £500,000, the margin is 20%.

Efficiency Ratios

Efficiency ratios determine how effectively a company utilizes its assets.

Return on Net Assets (RONA)

Formula: Net Income / Net Assets

Purpose: Measures the return generated by total net assets.

Example: If net income is £200,000 and net assets are £1,000,000, RONA is 20%.

These financial ratios help businesses and investors assess a company’s financial standing and performance efficiently.

Asset Turnover Ratio

Formula: Revenue / Total Assets

Purpose: Indicates how efficiently a company uses assets to generate sales.

Example: If revenue is £1,000,000 and total assets are £500,000, the ratio is 2.0.

Inventory Turnover Ratio

Formula: Cost of Goods Sold / Average Inventory

Purpose: Measures how quickly inventory is sold.

Example: If COGS is £600,000 and average inventory is £150,000, the ratio is 4.