Financial Ratios Explained: Formulas and Examples

A financial ratio turns two numbers from the financial statements into one number you can compare. A company with $120,000 of current assets tells you little on its own. Against $80,000 of current liabilities it tells you a lot. In a first accounting course the ratios arrive a few at a time across the book, which is why students often know the formulas separately but cannot say which statement each one draws from.

This post groups them by the question they answer. The financial ratio calculator computes all of them from statement figures and shows the working. The definitions below follow the course's own cards, including its rounding rules.

Liquidity: can the company pay what is due soon?

Liquidity is the ability to turn assets into cash to meet short-term obligations. These three use only current accounts from the classified balance sheet.

The quick ratio leaves out inventory and prepaid items, which are harder to turn into cash quickly. The text gives roughly 1.5 to 2 as a common current ratio target, but that is a rule of thumb that varies by industry, not a requirement. Compare across years and against peers.

Examples: current assets of 112,000 and current liabilities of 56,000 give a current ratio of 2.00, and 100,000 against 42,000 gives working capital of $58,000. Company J has current assets of 158,500 and current liabilities of 141,000; Company K has 122,000 and 104,000. J has the larger balances, but K has the higher current ratio, about 1.17 against 1.12. Working capital is a dollar size and the ratio is a proportion, so compare companies on the ratio, not on the dollar amounts.

Another useful trap: if a company pays 10,000 of Accounts Payable in cash, current assets and current liabilities both fall by 10,000, so working capital does not change, but the current ratio does.

Profitability: how much is left after costs?

The gross profit margin ratio comes from the multi-step income statement:

• Net sales = Sales - Sales Discounts - Sales Returns and Allowances
• Gross profit = Net sales - Cost of goods sold
• Gross profit margin ratio = Gross profit / Net sales

Harbor Supply Co. has sales of 300,000, sales discounts of 2,000 and returns and allowances of 4,500, so net sales are 293,500. With cost of goods sold of 180,000, gross profit is 113,500 and the ratio is 113,500 / 293,500 = 38.7%. The course shows these margins as percentages to 1 decimal place.

Net profit margin, return on assets and return on equity are common in textbooks and are built the same way, with net income over net sales, total assets and equity. They are not defined in the course's cards, so check which definition your own instructor uses, especially whether assets and equity are year-end or averaged.

Efficiency: how fast do balances turn over?

Turnover ratios use an average balance, which is (beginning + ending) / 2, because a balance at one date can be unrepresentative.

Receivables. Accounts receivable turnover = net credit sales / average accounts receivable, rounded to 2 decimals. Days' sales in receivables = 365 / turnover, using the rounded turnover. Northgate Corp. has net credit sales of $900,000 and receivables of $110,000 at the start of the year and $130,000 at the end. Average receivables are 120,000, turnover is 7.50, and days' sales are 365 / 7.50 = 48.67 days. Only credit sales belong in the numerator, because only credit sales create receivables. A higher turnover means faster collection. If turnover rises from 6.00 to 8.00 with terms unchanged, customers are paying faster.

The rounding order matters. The course rounds turnover to 2 decimals first and then divides 365 by that rounded figure. For net credit sales of $550,000 with average receivables of 65,000, turnover is 8.46 and days' sales is 365 / 8.46 = 43.14.

Inventory. Inventory turnover = cost of goods sold / average inventory. Days' sales in inventory = average inventory / (COGS / 365), which equals 365 / turnover. Harbor Supply Co. has COGS of $73,000 and average inventory of $20,000. Turnover is 73,000 / 20,000 = 3.65 times. Daily COGS is 73,000 / 365 = 200, so days' sales in inventory is 20,000 / 200 = 100 days.

Note the numerator: inventory uses cost of goods sold, not sales.

Leverage: how is the business financed?

Debt-to-equity = total liabilities / total stockholders' equity. The course card marks this as a standard textbook treatment from outside the book, so it follows the usual definition rather than an OpenStax derivation. Debt financing means required payments and no dilution of ownership. Equity financing has optional dividends and can dilute existing owners. If you are looking at the same idea from an investor's side, the bond yield calculator covers the return on the debt itself.

Per-share and cash measures

Two more from later units. Basic EPS = (net income - preferred dividends) / weighted-average common shares outstanding, and the price-earnings ratio = market price per share / EPS. The weighted average multiplies shares by the months outstanding over 12: 600 shares for 3 months and 1,100 for 9 months gives 600 x 3/12 + 1,100 x 9/12 = 975.

Free cash flow = operating cash flow - capital expenditures - cash dividends paid. The cash-flow ratios built on it, free cash flow to sales and to assets, are not useful when free cash flow is negative. A negative figure may point to a liquidity concern, or just to one large purchase financed from reserves.

Which statement does each ratio use?

Practicing it

The usual errors are mechanical: using sales instead of COGS for inventory, using total sales instead of credit sales, forgetting to average, and rounding turnover at the wrong step. Do the setup from memory, then compute. Recalling the formula is active recall at its simplest, and spacing the formulas across weeks is what keeps them from blurring together.

Liquidity ratios are in unit 5, gross margin in unit 6, receivables in unit 9, inventory in unit 10, and free cash flow in unit 16. What's in Financial Accounting maps the whole course, and how to study for financial accounting covers the order to take it in. Every calculation above is a typed card in the free Financial Accounting course.