What is Ratio Analysis: When to Use it, Monitoring Change

Globally, ratio analysis is one of the most important management tools. What is ratio analysis looks at the multiple uses of ratios. How ratios, also known as performance indicators, can identify positive and negative changes in business operations. The identification of these changes can positively influence future strategic planning, decision and operational control.

Ratio analysis, whilst primarily an internal control process, is also a key tool used by investors in assessing the viability of current business customers and future business clients.

When to use it

When you perform ratio analysis you are comparing historical data for example, the previous year’s financial statements against the current years financial statements. 

Whilst ratios, also called performance indictors, are primarily an internal management tool, they have equal value to external investors and lenders who want to gauge the viability and health of their clients' or potential client's business.

Performance indicators identify all changes in trading, production and operational efficiency. Ongoing, monitoring for change is more cost effective as it allows management to plan for future changes rather than react to a change when it happens.

In theory and to demonstrate the scope of analysis; every time a manager thinks, 'I wonder if that could be better', a quick ratio calculation, will deliver the answer provided the data is available to compare.

You'll see many of the popularly used performance indicators later in this blog and whilst the list is comprehensive, what you see is merely a drop in the ocean. The strength and success of ratio analysis is in the infinite range of ratio possibilities, with most being uniquely developed within individual companies.

Monitoring change

Market trends

Trading changes can occur at anytime through shifts in global events, changing market trends, variations in product life cycle, changes in production, natural seasonal variation or higher levels of competition.

Any or multiple changes can affect trading activity so management require an analysis process capable of identifying and measuring the effect of each change. Not all changes require action, but a constant awareness of all changes is a good reflection on the effectiveness of the management team.

The more effective these management processes are, the faster change is identified and the sooner plans can be made.

Global Changes

There is little a business can do to avoid the affect of global events on their business. The event is often unexpected giving little or no notice.

An example of this was the war in Ukraine and the effect it had on oil prices. Every business in the UK suffered significant utility cost increases, which affected trading prices and trading levels.

In this sort of situation owners walk a tight rope of trying to absorb the higher costs, keeping staff employed and trying to grow sales to compensate.

Not all additional costs can be absorbed so hard decisions have to be made. Should selling prices be increased to a customer base that are also struggling. Increases risk a reduction in sales and customer loyalty. Or should measures be taken to reduce operational costs, which could be reducing staff levels.

In the situation above, ratio analysis would be at the forefront of measuring the effects overall on the business. Based on the analysis, ongoing reactive management decisions will be made. In cases like this, the responses can only be reactive instead of planned because of the immediacy and transient nature of the event.

Product life cycle

Most changing market trends can to a degree be predicted because they rarely change over overnight. This is particularly the case in manufacturing of large industrial products. The ongoing production and profitability analysis would initially highlight a slow shift either upwards or downwards. This indicator gives management the opportunity to plan their future responses.

In the case of the trend rising, decisions would be made on the sustainability of the rise. Then whether to increase production whilst also considering all associated costs for instance, a potential that borrowing is needed or additional staffing. When able to future plan, decisions are more considered and better deals can be forged to meet any changes.

In the case of a downward sales trend the decisions are more complex. Initial analysis would assess the period of time available to change the trend to rising, but is that possible. Many questions will be asked:

• Can the trend be turned around or is the product outdated and heading towards obsolete?
• Has the market trends changed towards more technologically advanced products?
• Does the company have the physical and financial capacity to match or improve on the advancement?
• Is there room in the market to join the advancement or is the market saturated?
• Is there a better, alternative direction for the company to take?

Every product will have a natural life cycle so it’s important to monitor sales of all significant profit earning products. Monitoring allows the right decisions to be made either to invest in extending the peak of the product life cycle, provided that is possible or ultimately, when to withdraw a product from sale.

Some product life cycles, particularly in retail, walk a very fine line of rapid rise and rapid fall, as I have experienced in my past companies many times. These short-term products are often referred to as fads, which can sometimes mask the rapid and huge profits fads can generate.

A high earning retail product such as a fad, can become on trend overnight and at its life cycle peak, have the demand way outstripping its availability. In these instances, the limitation of ratio analysis is very apparent as there isn't the time to generate the data for any reliable analysis.

With retail 'trend products', the end of the life cycle is usually as rapid as its initial start and knowing when to stop ordering, is down to the expertise and instinct of the managers. It's a decision that is never exactly accurate and inevitability, some obsolete stock is left.

Changes in production

Operational ratios are also key measures in production output to ensure a product remains profitable. There are several ways in which production profitability can change.

Volume of items produced can increase or decrease. It is important to quickly know why, because profitability is based on expected output and not actual output.

Reasons for production changes

• Has old machinery become less productive or less reliable?
• In contrast, has new machinery become more efficient increasing output per hour? 

Likewise, the cost of materials and labour will be analysed for production cost variance and production efficiencies. For instance, if labour costs have increased, why?

• Is it down to pay increases?
• Is it poorer quality materials requiring higher skilled labour or an increase in labour hours per product.

In the latter instances, the productivity ratios are likely to see a positive rise in material costs and an adverse decline in labour costs.

Seasonal variation

When measuring a products overall performance, it’s necessary to have accurate information, which includes recognising and accounting for seasonal variations.

For example, winter coats will be a top seller from early autumn to late winter and an abysmal seller throughout the summer. Calculating seasonal variations to adjust for winter products or equally summer products, will smooth out the spike effect of the variation to show the products true profitability.

Competitive Edge

All astute businesses will monitor their competitors performance in the hope that they can gain a competitive edge. Whilst it isn’t possible to know a competitors product by product performance, it is possible to monitor their sales, promotions, product changes, product launches and revamp launches.

By monitoring their trading activity, it is possible to accurately assess through ratio analysis, how the competitor activities are growing and affecting your company's sales. This kind of analysis allows company's to take responsive market actions.

In summary

Operational efficiencies are constantly changing often due to uncontrollable external factors.

Constant ratio analysis will identify and highlight areas where decisions are required to sustain operational stability.

Some decisions will be significant and affect staff, sales or the way a business is run.

Other decisions, will be small and unnoticed, but none the less contribute equally to the profitability and viability of the company's financial health.

How financial ratio analysis links to the Income Statement and Balance Sheet

The figures for financial ratio analysis will come either from the Income Statement (Profit and Loss) or Statement of Financial Position (Balance Sheet).

If the financial ratio analysis is regarding trading activities i.e. monitoring changes in turnover, cost of the goods sold, gross and net profit then the ratios will be calculated from the Income Statement. These ratios are collectively called profitability ratios.

In contrast, if the ratios are measuring the Company's total asset worth, including intangible assets or the debt of the company, the measurements are taken from the Statement of Financial Position. Depending on what is being assessed the ratios could be debt to equity ratios, quick ratios or collectively financial ratios.

When ratios mislead and what to pair them with

Ratios are excellent tools that business management cannot do without. However, as with any business tool, they have limitations. For a business to gain optimum performance that they can trust from the ratios calculated, they must be aware of the pitfalls that accompany financial accounting ratio analysis.

Formula playbook: The main families of ratios

Below are the main families of accounting ratios formulas and ratio calculations used to some degree in in most businesses.

Profitability ratios

Measure how effectively a company turns revenue into profit. Profitability ratios are essential for evaluating a company’s financial performance and understanding where stock prices have fluctuated or operational activities have become less efficient.

Common performance indicators include:

• Gross Profit Margin Ratio = (Gross Profit ÷ Revenue) × 100
• Operating Profit Margin = (Operating Profit ÷ Revenue) × 100
• Net Profit Margin = (Net Income ÷ Revenue) × 100

The following ratios determine if your business can generate profits effectively from its assets and equity.

• Return on Assets (ROA) = (Net Income ÷ Total Assets) × 100
• Return on Equity (ROE) = (Net Income ÷ Shareholders Equity) × 100

Liquidity ratios metrics

Liquidity ratios show the company’s ability to pay its operational debts as they fall due. Without strong liquidity, the business is at risk of falling into debt with its suppliers, which long-term if not resolved, would cause the business to close.

Main performance indicators for liquid assets:

• Current Ratio = (Current Assets ÷ Current Liabilities)
• Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
• Cash Ratio = (Cash + Cash Equivalents) ÷ Current Liabilities

Solvency or Leverage ratios

Solvency ratios examine long-term stability and debt structure. They reveal a company’s ability to service its debt by making long-term interest payments and meeting all debt obligations as they arise.

Key examples:

• Debt to Equity Ratio (D/E) = (Total Liabilities ÷ Shareholders Equity)
• Debt Service Coverage Ratio (DSCR) = (Net Operating Income ÷ Total Debt Service)

A strong DSCR and low D/E indicate resilience under changing market conditions and market volatility.

Efficiency or Activity ratios

Efficiency ratios measure how well a company uses its assets to generate sales and control costs. They reflect on the operational efficiency and the company's asset management skills.

Typical ratios include:

• Inventory Turnover Ratio = (Cost of Goods Sold ÷ Average Inventory)
• Receivables Turnover = (Credit Sales ÷ Average Accounts Receivable)
• Payables Turnover = (Cost of Goods Sold ÷ Average Accounts Payable)
• Cash Conversion Cycle = (Inventory Days + Receivable Days – Payable Days)

The above evaluate whether the working capital is being utilised effectively in current performance and effectively to support future growth.

Samples of key financial ratios and interpretations

Market value -financial ratios analysis

Is a measure of valuing a company’s stock by comparing it to its financial performance data. This can then assess whether there is an over or under share valuation based on industry norms. Example: Earning Per Share and E.B.I.T.D.A

E.B.I.T.D.A stands for Earnings Before Interest, Taxes, Depreciation and Amortisation. It is a measure of the profitability of a company based on its core operational performance.

By removing the costs of borrowing and non-monetary entries i.e. writing down of assets, it shows a momentary picture of the money generated by a business in its daily trading activities.

E.B.I.T.D.A is frequently used as the starting point of negotiations for a company buyout.  It is only a basis though and many other company ratios and factors will be discussed and agreed before a deal is reached.

Other factors:

• Overall financial health of the company
• Debt and other liabilities - Borrowed capital
• Income generated profits - Dividend yield
• Market position - Stock market performance
• Future growth potential - Industry stability
• Goodwill and reputation

Trend analysis

Trend analysis looks at how ratios change over time. You might review the current ratio, net profit margin, and efficiency ratios year on year to see whether profitability and liquidity are improving or declining.

A selection of the questions asked of those ratios:

• Is there consistent growth in operating profit?
• Are expenses rising faster than sales?
• Is working capital tightening due to higher credit terms?

Plotting your findings on a graph shows instant movement that supports trend analysis for better planning.

Whilst the ratio examples listed above are some of the generic financial ratios that apply to all industries, it’s important to understand that there are 1000’s of industry or company specific formulas in use daily. 

Financial analysis generally compare current performance against historic data to best inform on growth, decline, efficiency and market share performance.

Some formulas however, are not year on year comparisons but product or even staff comparisons.

For example, if you wanted to optimise the efficiency of product stock ordering system, both in the frequency of the order and the quantities ordered, you would calculate the ratio of how many times each product is turned over per month. You can also calculate whether a product hits a 'stock out' position during the period between orders and if it does, for how many days. 

The ratios above will show you if the current re-order process is the ideal number of days apart and whether the right quantities are being ordered each time. However, identifying the ratio results is not necessarily a requirement to change. Other factors need to be considered:

• Bringing the re-order point forward would cost more in deliveries and storage holding costs annually. Can the additional profit generated justify the additional costs?
• Bringing the re-order point forward would require the previous order to be paid sooner. How does this affect the company's cash flow? If the order date is brought forward then suppliers will be paid faster, which means it is less likely that credit customers will have paid us before the supplier bill fall due. This kind of knock on effect will significantly affect working capital.
• If there are 'stock outs' of certain products, can those product quantities be increased at the current re-order point? Is there capacity to store more of the 'stock out' products?
• Is the profit margin on the stock out products sufficient to require solving the stock out issue?
• A positive 'stock out' consideration in the retail or hospitality sector is that very popular items selling out, allows other products to sell creating a more balanced overall stock rotation.
• In an ideal world, you would only stock top selling items, but that would never work. It is the full range of products that generates the buyers interest to then buy their favourite items. If only the top products were stocked, the display would be unappealing.

Financial ratios analysis and trend analysis, when done well, allows management to fine tune every aspect of their business operations for optimum efficiency. Ratio calculations are not solutions in themselves, they are identifiers that initiate informed decisions for growth and gaining the competitive edge.

Visualising Trends

A calculated ratio is only useful if the information is easily readable to the end user. It’s frequently said that a picture speaks a thousand words and in statistics this is usually true. This term can be expanded further by saying, the best analysis is that which achieves the best readability.

Each set of statistics requires thought as to the best diagrammatic presentation otherwise, the efforts of producing the data is wasted. 

The following diagrams are examples of a poor and then a good choice of diagrammatic presentation. The tables and diagrams are showing the same trends of four different ratios over a period of eight years

• Reading the data above, can you immediately identify the trends of each ratio?  The answer is no.
• ow look at the same data given in graph format below. Immediately, it is easy to see the trend has an upward trajectory in every set of data and importantly, the information is easily read by accounting and non-accounting users

Peer Benchmarking

When is ratio analysis important?

A ratio is only worthwhile, if its calculations add valuable insight for the company to benefit and grow from. This particularly applies to industry average and peer benchmarking.

Liquidity can also be compared, but with limitations:

• First and foremost, does your company have a liquidity problem?  If there’s a strong working capital then there is little need for comparison.
• Do you know the competitors payment terms with their suppliers and credit customers? If you don’t, then you don’t have reliable base data to compare.
• Are the competitors volume of credit customers and suppliers the same as yours? If they are not, then the base data is skewed.

eer benchmarking is good and useful as a ballpark guideline, provided your ratio expectations remain aware of its limitations. Having said this, there are areas where an analysis of competitors financial statements can be useful to gauge potential weakness in their future prospects. 

They say numbers don’t lie and they don’t, provided you know where and what to look at.  

Numbers can give you a great insight into a competitor's financial health including the risks it may encounter in its future health. A company may be riding high at the moment, but is that sustainable?

A good measure is to review their balance sheet.

Look at the non-current asset value. It may total millions at cost and on face value look impressive, even daunting, but how old are those assets?

Look at the value of the accumulated depreciation, is it nearly equal to the asset cost value? What is the carrying value.  The carrying value (net book value) is the adjusted worth of the usage left in the asset over time. A low net book value points to the assets being old and unlikely to produce at the capacity of modern machinery.

More importantly, old machinery, which can be subject to unreliability, is less likely to be able to respond to the requirements of market changes and trends. 

This isn’t necessarily bad, all assets have a life span and will need replacing at some point, but is the competitor in a position to replace when the time comes?

What is the company’s leverage ratio? If borrowing is low then they are able to renew. If borrowing is already high and the asset replacement is imminent and costly:

• Are they able to replace the assets?
• What will additional borrowing do to the stability of their company?
• How will the liquidity of their company be affected?
• Will older assets affect the market position of their company?

The above is an example of how ratios can tell you the hidden story behind what on face value is a strong company.   

Deep dive on the Balance Sheet-driven ratios

To deep dive on the balance sheet-driven ratios is to show the positive and potentially negative positions of the Company's assets and debt position.

Both financial statements give the overall financial picture of a business and in simple terms, the balance sheet ratios show the good and not so good picture i.e. what the company owns and what the company owes.

This doesn’t imply that debt is bad, it isn’t, it’s a fundamental part of daily operations that allows a company to successfully trade. Debt only becomes bad, if a company has over-borrowed and in doing so, has over-stretched its ability to repay.

Remember in all business, CASH IS KING - if the cash can't meet the repayments and operational costs, it is no longer king putting the company's liquidity in jeopardy.

What is also important to remember is no single financial ratio will tell the whole story.

Working capital mechanics and operating cycle

The working capital mechanics i.e. current assets minus current liabilities is the beating heart of any company. It is the money that flows in and out of the business daily to support the operating cycle.

The operating cycle also known as the cash conversion cycle is the period of time it takes to start and finish a trading cycle. 

Industry average:

• The cycle begins with cash being converted into raw materials.  Or spent on goods ready for resell.
• Raw materials go through a number of processes called work-in-progress to eventually become finished good for re-sale. 
• The goods whether manufactured or purchased ready to sell, are then sold to a customer on credit. Who, depending on the credit agreement terms, will pay for the goods on a due date in the future, usually 30 days.
• Goods can also be sold to cash paying customers.
• At the point of the money being received from the credit customers, the operating cycle is complete, as the original money invested + profit earned in the transaction has now been converted back into money.
• The cycle then begins again. 

Different ratio expectations:

• Operating Cycle equals = Inventory days + receivable days = the time from buying the stock or producing the finished goods to selling it to the customer.
• Cash Conversion Cycle = Inventory days + receivables days – payable days = the time from paying the supplier to receiving the money from the customer.

Current vs Quick vs Cash: when each is decisive

In order to make a good decision on which ratio is best to assess liquidity, it is necessary to look at the reality of available funds i.e. assets that are either cash or are quickly converted into cash.

Common pitfalls include:

• Overlooking inventory turnover ratio, which shows how efficiently stock is sold and replaced.
• Ignoring receivable delays, which inflate liquidity on paper but restrict real cash flow.
• Misinterpreting data affected by window dressing or year-end adjustments that don’t accurately reflect in the company’s financial statements.

A good rule of thumb if investing: question their suppliers and check supporting notes to the accounts before forming a conclusion.

Limits, biases & normalisations

All assessment of performance has imperfections which is why it is important to highlight the limitations to ratio analysis below including it's pitfalls.

• The drawback of ratio analysis is its linear approach that does not consider real internal events that fall outside of the linear calculation.
• Ratio analysis can be calculated to infinity, which in reality is not possible
• Ratio analysis relies on evenly matched data in order to produce accurate data
• Ratio analysis identifies the story behind the numbers, but the story identified is historical and not necessarily the current picture.
• Forecasting future performance from historical data does not identify changing trend.
• Ratio analysis does not account for the affects to net profit across the life of an asset for leasing, capitalisation vs an expense.
• Ratio analysis does not account for the affect aged assets would have on manufacturing and trading
• A ratio analysis does not account for window dressing and subsequent normalisation of the accounts.

Policy differences – IFRS vs UK GAAPS. 

In UK GAAP’s costs are expensed in the accounts in the same period as they are incurred. This then ensures an accurate matching of the costs incurred to generate the income. For example, commission on sales is included in the accounts in the month that it was earned from the sales and not when it is paid to the salesman.

Whereas IFRS state, that provided contract related expenses meet a certain criteria, they can be capitalised and amortised (depreciated) across the period of the contract.

One-offs and window dressing; how to normalise.

Regular non-current asset sales, non-standard trading income and window dressing, do not give a true and fair view of the health of the accounts being produced, which a company is legally bound to show.

To normalise, the company must:

• Stop selling on a regular basis exceptional or non-recurring items that inflate short-term profits
• Ensure expenses are accounted for in the period they occurred.
• Ensure all transactions are classified correctly to reflect company performance.
• Prioritise measurable long-term growth instead of relying on short-term one-off boosts to profits.
• Improving operating efficiencies and effectiveness to increase profit.
• Ensure transparency in the accounts to show a true, reliable and fair view.

Industry benchmarks & ‘what good looks like’

Every ratio makes sense only when you know what to compare it with.

The Office of National Statistics https://www.ons.gov.uk/ has amazing data on all industries and when used as a potential guideline, can have significant value in decision making, growth and market awareness. 

Peer benchmarking is a valuable tool to measure a company’s performance against a small sample of competitors. However, care has to be taken if you use ONS data or a competitors data for decision making purposes. As previously written, source data has to be comparable to your data for the ratio to have true value and meaning.

ONS data is an average of multiple sets of data from large and small companies so cannot be accurately aligned with your base data. However, peer comparison accuracies can be valuable for certain ratios such as sales growth, profitability, leverage and efficiency. 

Industry benchmarks are helpful in allowing companies to look at the wider aspects of the industry to identify potential trends, opportunities and threats.

Retail ratio comparisons within the sector - Indicative ranges by sectors

A good ratio rating is not generic across a sector and the best demonstration of this is in the retail sector.

For example, an ideal current ratio in most sectors including retail is 1.5-2.0 to 1. However this changes by how quickly stock is turned over and the speed that the business generates sales. 

Supermarkets with a fast turnover of stock (inventory) are likely to operate at a ratio of 1.0-1.5 to 1. with many of the very large supermarkets operating very successfully at around 0.75-1 to 1.

This in theory means the supermarket may not be able to pay current liabilities as they fall due. However, in practice, the sheer speed and volume of inventory turnover means bills are comfortably paid when due.

In contrast, in the high-end product retail sector for instance luxury yacht building. The current ratio would aim to be between 2.0- 4.0 to 1 because of the slow turnover in yacht sales. 

Typical ranges vary:

• Fast-turnover retail: slim margins but rapid turnover; current ratio often 1.0–1.5.
• Software: high gross profit margin ratio (70–90%) but higher R&D costs.
• Manufacturing: moderate liquidity and high debt to equity ratio due to capital investment.
• Banks: lower liquidity, but strong interest coverage ratio and solvency ratios.

When analysing different financial metrics, remember that profitability and liquidity must be balanced. For instance, a company may show strong cash flow but lower earnings compared to peers because of heavy reinvestment or depreciation. These nuances matter when interpreting financial ratios accurately.

How to source, cite and refresh benchmarks - Comparability cautions

Reliable sources include:

• Annual reports from Company's House.
• Industry associations and government statistics.
• Financial databases and analyst reports.

Update benchmarks frequently to reflect shifts in market conditions, inflation, and future growth expectations. This ensures your comparison remains aligned with current industry trends and market growth prospect ratios.

No two companies are identical especially if comparing overseas trading. Scale, geography, and business model influence outcomes. Always adjust data for currency differences and local regulations before comparing a company’s financial performance with its peers.

Ratios should guide, not dictate, your analysis of financial and operational health.

Worked walk-throughs

Let’s see how ratio calculations look in real scenarios.

Retail Example:

Retail businesses depend heavily on inventory management and rapid turnover. Here’s how ratios reveal their efficiency.

Software Example:

Software firms prioritise scalability and profitability.

This highlights a healthy model with minimal debt obligations and consistent future growth potential.

Frequently Asked Questions