Financial ratio analysis

What financial ratio analysis is

Financial ratio analysis is the calculation and interpretation of relationships between figures in the financial statements, such as current assets to current liabilities or profit to capital employed, to judge a business's liquidity, efficiency, profitability, solvency and cash generation. It matters because ratios turn raw totals into comparable signals that lenders, investors, auditors and managers use to spot risk and trends.

A ratio on its own says little. It becomes useful when compared with the same business last year, with budget, with covenants or with peers in the same industry, and when several ratios are read together to tell one story. This guide computes every main ratio on a single worked set of statements, then shows how to read them. For the basics of the statements themselves, see our guide on how to read financial statements.

The worked set of statements

The company is a mid-sized distributor reporting under IFRS. Figures are in EUR thousands for the year to 31 December 2026, with a few 2025 figures for trend. For simplicity the ratios use closing balances; in practice averages of opening and closing balances are better for any ratio that mixes a period flow (revenue, cost of sales) with a point-in-time balance.

Operating expenses include depreciation of 480. The balance sheet totals 9,000 on both sides. Comparative 2025 figures: revenue 10,000, cost of sales 6,200, gross profit 3,800, operating profit 1,400, trade receivables 1,260, inventory 950 and trade payables 1,020.

• Revenue 12,000; cost of sales (7,800); gross profit 4,200
• Operating expenses (2,760); operating profit (EBIT) 1,440
• Finance costs (240); profit before tax 1,200; tax (300); profit for the year 900
• Non-current assets: property, plant and equipment 5,400
• Current assets: inventory 1,560; trade receivables 1,800; cash 240; total 3,600
• Equity 4,200; non-current borrowings 2,400
• Current liabilities: trade payables 1,300; short-term borrowings 700; tax payable 400; total 2,400

Liquidity ratios

Liquidity ratios ask whether short-term obligations can be met from short-term resources. The current ratio is 3,600 divided by 2,400, which is 1.50. The quick ratio excludes inventory, the least liquid current asset: 2,040 divided by 2,400, 0.85. The cash ratio uses cash alone: 240 divided by 2,400, 0.10.

There is no universal right level. A supermarket that collects cash immediately and pays suppliers in 60 days can run safely below 1.0; a manufacturer with slow-moving stock may be stretched at 1.5. Here the quick ratio below 1.0 and a cash ratio of 0.10 mean the company depends on collecting receivables and on its short-term facility to pay its bills. Watch the trend and the composition, not just the number: a current ratio that improves because inventory is piling up is a warning, not a comfort.

Working capital efficiency and the cash conversion cycle

Days sales outstanding (DSO) is receivables divided by revenue, times 365: 1,800 divided by 12,000 times 365, about 55 days, up from 46 in 2025. Days inventory outstanding (DIO) is inventory divided by cost of sales, times 365: 73 days, up from 56. Days payables outstanding (DPO) is payables divided by cost of sales, times 365: about 61 days, against 60.

The cash conversion cycle is DSO plus DIO minus DPO: 55 plus 73 minus 61 gives 67 days, against 42 days in 2025. Each extra day of receivables ties up about EUR 33,000 (12,000 thousand divided by 365) and each extra day of inventory about EUR 21,000 (7,800 thousand divided by 365). Had 2025's collection and stock days held, receivables would be about 1,512 and inventory about 1,195, so the longer cycle has absorbed roughly EUR 0.6 million of cash. This single measure explains more about the company's cash position than any profitability ratio. Our guides on working capital and on cash flow versus profit explore the levers in depth.

Asset turnover completes the efficiency picture. Revenue divided by total assets is 12,000 divided by 9,000, 1.33 times; revenue divided by property, plant and equipment is 12,000 divided by 5,400, 2.22 times. For a distributor, falling fixed-asset turnover usually means warehouse capacity was added ahead of volume, which is worth asking about before the depreciation charge surprises the margin.

Profitability and return ratios

Gross margin is 4,200 divided by 12,000, 35.0%, down from 38.0%. Operating margin is 1,440 divided by 12,000, 12.0%, down from 14.0%. Net margin is 900 divided by 12,000, 7.5%. EBITDA is operating profit plus depreciation, 1,920, a 16.0% margin. Revenue grew 20%, but margins fell at both the gross and operating level: growth was bought with price or mix. Our guides on gross profit versus net profit and on EBITDA cover these measures and their adjusted variants in depth.

Return on equity is profit for the year divided by equity: 900 divided by 4,200, 21.4%. Return on capital employed (ROCE) is EBIT divided by capital employed, where capital employed is equity plus non-current liabilities (equivalently, total assets minus current liabilities): 1,440 divided by 6,600, 21.8%. ROCE is the better measure of operating performance because it is not distorted by how the business is financed; compare it with the pre-tax cost of borrowing to see whether growth funded by debt creates value.

Solvency and leverage ratios

Total borrowings are 2,400 plus 700, EUR 3,100 thousand. Debt to equity is 3,100 divided by 4,200, 73.8%. Net debt is borrowings minus cash, 2,860, and net debt to EBITDA is 2,860 divided by 1,920, 1.49 times. Interest cover is EBIT divided by finance costs: 1,440 divided by 240, 6.0 times.

Gearing has two common definitions, so always state which one is used. Debt to equity gives 73.8%; debt to total capital (debt divided by debt plus equity) gives 3,100 divided by 7,300, 42.5%. Both describe the same balance sheet. Whether lease liabilities count as debt is the other definitional choice that changes the answer, and after IFRS 16 it can move gearing materially for retailers and logistics companies.

Lenders set covenants on exactly these measures. Typical covenant levels in mid-market lending are a maximum net debt to EBITDA somewhere between 2.5 and 3.5 times and a minimum interest cover of around 3 to 4 times, though the actual numbers depend on the sector, the lender and the loan. Always read the facility agreement: covenant definitions of EBITDA and debt often differ from the figures in the published accounts, for example by adding back one-off costs or excluding lease liabilities.

Cash-based ratios

Profit ratios can look healthy while cash drains away, so pair them with cash ratios. Cash generated from operations, before interest and tax, is profit before tax 1,200, plus depreciation 480, plus finance costs 240, minus the increase in receivables 540, minus the increase in inventory 610, plus the increase in payables 280: EUR 1,050 thousand. After interest paid of 240 and tax paid of 250, net operating cash flow is 560. Our guide on the cash flow statement under the indirect method builds this reconciliation line by line.

Cash conversion (cash generated from operations divided by EBITDA) is 1,050 divided by 1,920, about 55%, well below the 80% to 100% that a stable distributor would usually expect. Operating cash flow to profit is 560 divided by 900, 0.62. With capital expenditure of 900, free cash flow is minus 340, which is why short-term borrowings exist. Note that where interest paid sits in the cash flow statement affects these ratios: IFRS 18 amends IAS 7 so that most companies classify interest paid in financing activities from 2027.

DuPont analysis: connecting the ratios

DuPont analysis splits return on equity into three drivers: net margin times asset turnover times the equity multiplier. Here that is 7.5% times 1.333 (revenue 12,000 divided by total assets 9,000) times 2.143 (total assets 9,000 divided by equity 4,200), which gives 21.4%, the same return on equity as before.

The split matters because the same return on equity can come from very different businesses. A luxury brand earns it through margin, a discount retailer through turnover, a bank through leverage. When return on equity rises only because the equity multiplier rises, shareholders are being paid for taking on more financial risk, not for better operations.

Reading the story, not the numbers

Put together, the ratios describe a company growing revenue by 20% while margins slip and 25 more days of cash are tied up in stock and receivables. Returns still look strong at over 21%, but free cash flow is negative and liquidity depends on the overdraft. The questions for management follow directly: which customers or products drove the margin fall, why inventory days rose by 17, whether the longer collection period reflects new customers on longer terms or weaker credit control, and how much headroom remains on the facility.

For an auditor, the same analysis is a risk assessment procedure under ISA 315, and the same ratios reappear as substantive analytical procedures and the overall review under ISA 520: the jump in inventory days points to valuation and existence risk, and the fall in gross margin points to cut-off or pricing errors as well as genuine trading. For a lender, it points to covenant risk long before a covenant is breached.

Pitfalls that mislead analysts

Most mistakes in ratio analysis come from comparing figures that are not comparable. Check each of these before drawing conclusions.

• Year-end balances can be window-dressed: a large receipt on 31 December flatters liquidity for one day
• Seasonal businesses give different ratios at every quarter end; use averages or the same point each year
• IFRS 16 leases raise EBITDA, operating cash flow and debt together, so pre-2019 and post-2019 ratios, or IFRS and some local GAAP ratios, do not compare directly
• Different accounting policies (depreciation lives, capitalised development costs, revaluation of property) move margins and returns
• One-off items such as disposal gains or restructuring costs distort a single year
• Definitions vary: EBITDA, net debt and capital employed have no single definition; state the one you use, as IFRS 18 requires for management-defined performance measures from 2027
• Industry norms differ so much that cross-sector comparisons are rarely meaningful
• Negative equity or a near-zero denominator makes a ratio meaningless rather than extreme

Getting ratio inputs from Skyline Nexus ERP

Ratio analysis is only as good as the classification behind it, and Skyline Nexus ERP handles that at the account-type level: each account type carries a Balance Sheet Liquidity classification (Current or Non-Current), a P&L Category (Cost of Goods Sold, Operating Expense, Other, Financial Expense) and a Cash Flow Activity, which decide where every account lands in the statements. That is what makes current assets, cost of sales and finance costs reliable inputs rather than a manual regrouping exercise.

In Fiscal Authority > Reports, the Income Statement (Profit & Loss) report can be run with Compare With set to Previous Period or Previous Year and shows a % of Revenue column, the Balance Sheet offers the same comparisons, and a separate EBIT & EBITDA Report is available. AR Aging and AP Aging reports give the detail behind receivable and payable days, and the statements export to Excel for the calculations.