Ratio Analysis: Types, Formulas and a Worked Example

Select the measure for the question you are investigating. A lender, supplier and equity researcher may need different evidence. A profitable business can still face a cash shortfall, while a high current ratio can include slow inventory or disputed customer invoices. No single result establishes business quality.

Cedar Supplies is an invented wholesaler. All figures below are INR thousands, both reporting years contain 365 days, and credit revenue excludes cash sales. The practice data has no prepaid expenses or other current assets. Debt means only interest-bearing borrowings for this exercise. Use these definitions consistently rather than mixing alternative formulas.

The quick-ratio definition is explicit because practice conventions differ. If a real data set contains prepayments or other assets that cannot promptly meet obligations, investigate whether they belong in the numerator. Also check whether a requested debt ratio includes leases, all liabilities or only borrowings. Record the convention instead of silently changing it between years.

Cedar's revenue rose by 20%, but operating profit remained INR 120 thousand. Gross margin fell by 2.5 percentage points and operating margin by 2 points. The arithmetic shows weaker margins on the additional sales; it does not identify the cause. Request product mix, selling prices, input costs, exceptional items and operating-expense detail before attributing the movement to poor cost control.

The unchanged current ratio conceals a shift in asset composition. Inventory increased by 50%, while current assets increased by 20%. The quick ratio fell from 1.2 to 1.0. Ask whether inventory is saleable, whether demand is seasonal and when obligations fall due. Calling the business safe merely because its current ratio is 2.0 would overlook those questions.

Receivables days increased by about 9.2 days. Review ageing, customer concentration, credit terms, disputes and receipts after the reporting date. A change in customer mix or agreed terms could explain part of the result. Avoid describing it as proven collection failure without the supporting invoice and payment evidence.

• Year-end balances can hide seasonal pressure; average balances may be more informative when reliable observations exist.
• Accounting policies, acquisitions and one-off items can impair comparisons.
• A zero or negative denominator can make a familiar ratio undefined or misleading.
• Industry context matters: a universal ideal ratio is rarely a sufficient decision rule.
• Ratios omit important qualitative evidence, such as customer disputes, product quality or financing restrictions.

Create a spreadsheet with separate input, calculation and interpretation sheets. Reproduce every value above, then change Year 2 inventory to 180 while keeping total current assets at 480. The quick ratio becomes 300 / 240 = 1.25 times; the current ratio remains 2.0. Explain how the same current-asset total can support different conclusions about composition. Label the exercise fictional and retain the original inputs so a reviewer can audit your work.

Read the balance-sheet format before choosing ratio inputs

Connect financial statements to analysis

Explore the Finance Operations module within the Masterclass

ACCA discusses interpreting performance with comparisons and context. CFA Institute groups analytical measures into activity, liquidity, solvency and profitability. The Cedar data, chosen formula conventions, calculations and questions are original educational material. Check the reporting framework and purpose before applying a ratio to a real business.

ACCA: assessing organisation performance

CFA Institute: financial analysis techniques