Financial Ratios

You’ll be able to

Explain why ratios are used to interpret financial statements
Calculate liquidity, profitability, and return ratios
Interpret what each ratio reveals about a business

Why ratios matter

Financial ratios turn raw statement figures into comparable measures of a firm’s health. A $1 million profit means little without context; a ratio relates it to sales, assets, or investment so it can be judged against past performance, competitors, or industry benchmarks. Ratios fall into families: liquidity (can the firm pay short-term bills?), profitability (how efficiently does it turn sales into profit?), and return/efficiency (how well does it use investment?).

Liquidity: the current ratio

The current ratio measures short-term financial health: current assets divided by current liabilities. It asks whether the firm has enough assets convertible to cash within a year to cover the debts due within a year. A ratio of 2.0 means $2 of current assets for every $1 of current liabilities — generally healthy. Below 1.0 signals possible trouble meeting obligations; a very high ratio may mean cash is sitting idle rather than being invested.

Profitability and return

The net profit margin — net income divided by revenue — shows how many cents of each sales dollar become profit; a 10% margin means $0.10 of profit per $1 of sales. Return on investment (ROI) — net profit divided by the cost of the investment — measures how efficiently invested money generates profit, letting owners compare very different opportunities on a common scale. Together these reveal not just whether a firm is profitable, but how efficiently it earns.

Key financial ratios

Current Ratio = Current Assets ÷ Current Liabilities · Net Profit Margin = Net Income ÷ Revenue · ROI = Net Profit ÷ Cost of Investment

Liquidity, profitability, and return. Margin and ROI are usually expressed as percentages by multiplying the result by 100.

Worked example

A business has current assets of $80,000 and current liabilities of $40,000. Over the year it earned revenue of $500,000 and net income of $60,000. Calculate its current ratio and net profit margin, and interpret each.

1.Current ratio = Current Assets ÷ Current Liabilities = $80,000 ÷ $40,000 = 2.0.
2.Interpret liquidity: a current ratio of 2.0 means $2 of current assets per $1 of current liabilities — the firm can comfortably cover short-term obligations.
3.Net profit margin = Net Income ÷ Revenue = $60,000 ÷ $500,000 = 0.12, or 12%.
4.Interpret profitability: a 12% margin means the firm keeps $0.12 of profit from every $1 of sales.

Answer: The current ratio is 2.0, indicating healthy short-term liquidity, and the net profit margin is 12%, meaning 12 cents of every sales dollar becomes profit. Together they show a firm that is both able to pay its near-term bills and reasonably profitable.

Checkpoint

A company has current assets of $150,000 and current liabilities of $60,000. What is its current ratio, and what does it indicate?

Tip

Match each ratio family to its question: liquidity = "Can we pay our bills?", profitability = "How much of each sale is profit?", and ROI = "Was the investment worth it?". Naming the question keeps you from applying the wrong formula.

Checkpoint

An investor puts $50,000 into a project that generates a net profit of $8,000 over the year. What is the ROI?

On the exam

Always convert ratio decimals to the form the question wants — a margin or ROI is normally stated as a percentage (multiply by 100), while the current ratio is left as a plain multiple (e.g., 2.0). Reporting the right format matters as much as the arithmetic.

Answer the 2 checkpoints as you read.