A business owner looking at a profit figure knows one thing about their company. A business owner looking at three or four ratios knows something considerably more useful: whether that profit is sustainable, whether the business can pay its bills next month, and whether money is trapped in places it should not be. This guide from The Finance Reveal explains the financial ratios worth tracking, part of our Making Money section. This is general information, not financial or accounting advice, and conventions vary by jurisdiction and industry.

What Ratios Actually Do

A ratio turns an absolute number into a relationship, and relationships are what make figures comparable. Knowing a business holds a certain amount of stock tells you very little. Knowing how many times that stock sells through in a year tells you whether the money tied up in it is working.

This matters most for comparison across time and against peers. A growing business will show larger numbers on almost every line, so growth alone reveals nothing about whether the business is getting better at what it does. Ratios strip out size and expose efficiency, which is why they sit alongside the statements our guide to the balance sheet describes rather than replacing them.

The Ones Worth Knowing

A small number of ratios cover most practical needs. The table below sets them out.

The current ratio measures whether near-term resources cover near-term obligations. A figure below one signals that more falls due soon than is available soon, which is the liquidity problem our guide to working capital examines. Very high figures are not automatically good either, since they can indicate cash sitting idle rather than being deployed.

Inventory turnover shows how many times stock sells through in a period. Low turnover means cash is locked in goods that are not moving, and in some sectors it also means obsolescence risk. Very high turnover can indicate efficiency, or it can indicate stockouts and lost sales. Retained earnings is not really a performance ratio but a running total of profits kept in the business rather than distributed, and it is worth tracking because it shows how much of the company’s growth has been self-funded.

Using Them Without Being Misled

The first rule is that ratios mean nothing in isolation. A current ratio of 1.5 is neither good nor bad until you know the industry norm and the direction of travel. Trends matter more than levels: a ratio deteriorating steadily over four quarters tells you more than any single reading, however healthy it looks.

The second rule is that industry context is decisive. A supermarket and a machinery manufacturer will show entirely different turnover figures, and comparing them tells you nothing except that they are different businesses. Compare like with like, or compare a business against its own history.

The third is that ratios can be managed. Figures measured at a single point, such as period end, can be flattered by timing decisions about when to pay suppliers or invoice customers. This is why anyone reading someone else’s accounts should look at several periods rather than one, and why an owner reading their own should be honest about what the timing reflects. Used properly, these figures are an early warning system: they tend to deteriorate before a crisis becomes obvious in the bank balance, which gives you time to act. That is the same discipline underlying the record-keeping our guide to bookkeeping basics encourages. The essential message is that ratios convert absolute figures into comparable relationships, that the current ratio, inventory turnover, and gross margin cover most practical needs, that trends and industry context matter more than any single number, and that period-end figures can be flattered by timing. For related basics, see our guide to margin versus markup, and explore the full Making Money section.

Frequently Asked Questions

How do you calculate the current ratio?

Divide current assets by current liabilities. Current assets are what will convert to cash soon, typically cash, money owed by customers, and inventory. Current liabilities are what falls due soon, such as supplier payments, short-term borrowing, wages, and taxes. A result below one indicates more falling due soon than is available to meet it, which signals liquidity strain.

How do you calculate inventory turnover?

Divide cost of goods sold by average inventory for the period. The result shows how many times stock sold through. Low turnover means cash is tied up in goods that are not moving and, in some sectors, carries obsolescence risk. Unusually high turnover may reflect genuine efficiency, or it may indicate stockouts and sales lost because goods were unavailable.

How do you find retained earnings?

Take the opening retained earnings balance, add the profit for the period, and subtract any distributions to owners. The result is the running total of profit kept in the business rather than paid out. It is not a performance measure in itself, but it shows how much of the company’s growth has been funded from its own earnings.

What is a good current ratio?

There is no universal answer, which is why the question is best rephrased. What matters is the norm for your industry and the direction over time. A ratio that looks healthy but has declined steadily across four quarters is more concerning than a lower ratio that is stable or improving. Very high figures can also signal cash sitting idle rather than being deployed productively.

The Bottom Line

A ratio converts an absolute figure into a relationship, and relationships are what make numbers comparable. Knowing how much stock a business holds says little; knowing how many times that stock sells through in a year says whether the money tied up in it is working. This matters most for comparison across time and against peers, because a growing business shows larger numbers on nearly every line, so growth by itself reveals nothing about whether the business is improving. Ratios strip out size and expose efficiency. A handful cover most practical needs. The current ratio, current assets divided by current liabilities, measures whether near-term resources cover near-term obligations, with a figure below one signalling strain and a very high figure sometimes signalling idle cash. Inventory turnover, cost of goods sold divided by average inventory, shows how many times stock sells through, where low turnover means cash locked in goods that are not moving and very high turnover may mean stockouts and lost sales. Gross margin, gross profit divided by revenue, shows how much of each sale survives direct costs. Retained earnings, the opening balance plus profit minus distributions, is a running total of profit kept in the business and shows how much growth has been self-funded. Three cautions govern their use. Ratios mean nothing in isolation, so a current ratio of 1.5 is neither good nor bad until you know the industry norm and the direction of travel, and trends across several periods tell you more than any single reading. Industry context is decisive, since a supermarket and a machinery manufacturer will always show different turnover, making cross-sector comparison meaningless. And ratios can be managed, because figures measured at period end can be flattered by decisions about when to pay suppliers or invoice customers, which is why several periods should always be read together. Used properly, these figures work as an early warning system, deteriorating before trouble becomes visible in the bank balance and buying time to respond. For related guides, see our articles on the balance sheet, working capital, and margin versus markup, and explore the full Making Money section. This article is general information, not personalized financial or accounting advice.