Financial ratios: formulas, ratio analysis and worked examples.

Financial ratios in accounting compare one figure in the accounts with another. Financial ratio analysis turns the figures in a set of accounts into ratios, so they can be compared: with last year, with a budget, with other businesses of a similar size, or with a lender’s limits. A profit of £150,000 means little on its own; a 10.3% net margin and 27.3% return on equity can be read against a sector straight away. Ratio analysis in accounting usually covers five families: liquidity, efficiency, profitability, gearing and investor ratios.

Liquidity ratios (can the business pay its short-term debts), efficiency or activity ratios (how quickly it collects, sells and pays), profitability ratios (margins and returns), gearing or leverage ratios (how much is borrowed and how safely), and investor ratios (earnings per share, price to earnings, dividend cover and yield). This page covers the first four with worked examples; investor ratios need a share price, so they apply mainly to listed companies.

For most owner-managed businesses, five key financial ratios do most of the work: the current ratio (liquidity), debtor days (cash collection), gross margin (pricing), return on capital employed (whether the business earns its keep) and interest cover (whether the debt is safe). Lenders add gearing; buyers add EBITDA. Which matters most depends on the question: a bank asks different questions from a buyer.

Divide one figure by another taken from the same set of accounts, for the same period, and express the answer the way the ratio is normally quoted: as a number (current ratio 2.00), a percentage (gross margin 40.0%), a multiple (asset turnover 1.55×) or a number of days (debtor days 36.5). Use averages of opening and closing balances where you can; LedgerIQ does, while the worked examples on this page use closing balances to keep the arithmetic easy to follow. The formulary above works as a financial ratios cheat sheet, with the financial ratios formulas set out one per entry.

Each one divides a measure of liquid assets by current liabilities. The current ratio uses all current assets; the quick ratio leaves out stock; the cash ratio uses cash alone. The five most often listed are those three plus the working capital figure (current assets less current liabilities) and the operating cash flow ratio (cash from operations divided by current liabilities).

Gross profit margin, operating profit margin, net profit margin, return on assets, return on equity and return on capital employed. The first three divide profit by revenue; the last three divide profit by the money used to earn it. All six, with worked figures, are in the profitability section above.

Efficiency ratios measure how hard the business works its assets: how many days customers take to pay (debtor days), how long stock sits (stock days), how long the business takes to pay suppliers (creditor days) and how much revenue each pound of assets earns (asset turnover). The first three combine into the cash conversion cycle.

Investor ratios relate profit and dividends to shares: earnings per share, the price to earnings ratio, dividend cover and dividend yield. They tell a shareholder what each share earns and what it pays out. They need a share count and usually a market price, so LedgerIQ, which works from the general ledger, does not calculate them.

Ratios are only as good as the accounts behind them: a misposted transaction moves every ratio that uses it. They describe the past, at one date, and a year-end balance sheet can flatter the position. Different definitions (gearing is the usual example) make comparisons unreliable unless you check the formula. Seasonal businesses need averages, not closing balances. And a ratio says what has changed, not why: you still have to read the ledger.

It makes businesses of different sizes comparable, shows trends that the raw figures hide, flags problems early (stretching debtor days, a slipping margin) and puts a set of accounts into the language lenders, buyers and boards already use.

A weighted score of five ratios that estimates the risk of business failure. For private companies the Z′ version uses book equity instead of market value: Z′ = 0.717 × working capital ÷ total assets + 0.847 × retained earnings ÷ total assets + 3.107 × EBIT ÷ total assets + 0.420 × book equity ÷ total liabilities + 0.998 × sales ÷ total assets. Above 2.90 is the safe zone, below 1.23 the distress zone. LedgerIQ’s Financial Health Scoring module calculates the Z′ version from the ledger.

Most valuers group the methods into four: earnings multiples (a multiple of EBITDA, EBIT or profit), revenue multiples (a multiple of turnover), discounted cash flow (future cash flows brought back to today) and asset-based methods (net assets, adjusted to market value). Capitalisation of earnings sits between the first and third; lists of five types of valuation methods usually count it separately. A valuation report usually runs several and weighs them.

Start from maintainable earnings: last year’s profit, adjusted for one-off items and a market-rate salary for the owners. Apply a multiple that suits the sector, size and risk to get an enterprise value, then deduct net debt to reach the equity value. That is the business valuation formula in its simplest form: maintainable earnings × multiple − net debt = equity value. Cross-check against a discounted cash flow and against net assets. For a quick estimate, the free business valuation calculator runs the multiples; LedgerIQ’s Business Valuation module runs six methods from the ledger itself.

Sales alone cannot tell you. Take two businesses with £1 million of sales. One keeps 20% as EBITDA, £200,000; at four times EBITDA it is worth about £800,000 before debt. The other keeps 5%, £50,000, and at the same multiple is worth about £200,000. Same turnover, four times the value: price follows profit, and the multiple follows how safe and repeatable that profit is.

Book value (the balance sheet figure), adjusted net assets (each asset restated to market value, liabilities deducted), replacement cost and liquidation value (what the assets would fetch in a quick sale). Asset-based methods suit property and investment companies and businesses that are not making a profit; for a profitable trading business they usually give the floor, not the price.