Which Financial Ratios Should You Use? Start With the Question
A current ratio of 2 sounds reassuring. But two businesses can report that same ratio while holding very different assets. The useful question is not “Which ratio looks good?” It is “What decision am I trying to understand?”
Choose a small set of measures that answers that question, calculate them consistently and investigate the underlying balances. A long dashboard of ratios can create an illusion of analysis if nobody explains the changes.
Match the measure to the question
| Question | Useful starting measures | What to inspect next |
|---|---|---|
| Can short-term obligations be met? | Current ratio, quick ratio, working capital | Timing, restrictions and quality of the assets |
| Are customers paying? | Receivables turnover and collection days | Ageing, credit terms, disputes and concentration |
| Is stock moving? | Inventory turnover and inventory days | Obsolescence, stockouts, seasonality and cost measurement |
| Where is profit retained or lost? | Gross, operating and net profit margins | Price, mix, costs, unusual items and classification |
| How much financial leverage is involved? | Debt-to-equity, interest coverage, debt-service coverage | Definitions, payment timing and contractual requirements |
| What drives shareholder return? | Return on equity and a DuPont analysis | Margins, asset efficiency and leverage together |
An original example: two current ratios of 2
Both fictional shops have current assets of 60,000 and current liabilities of 30,000. Their current ratio is 2. Assume the following assets are unrestricted and the receivables shown are the relevant net balances.
| Current asset | Shop A | Shop B |
|---|---|---|
| Cash | 15,000 | 3,000 |
| Net receivables | 30,000 | 6,000 |
| Inventory | 15,000 | 51,000 |
| Total current assets | 60,000 | 60,000 |
| Quick ratio: cash plus net receivables divided by 30,000 | 1.5 | 0.3 |
The quick ratios reveal a difference that the current ratios hide. They do not establish that Shop A is safe or Shop B is in difficulty. Shop A’s customers might pay late; Shop B might sell stock quickly for cash. Examine collection, inventory and payment timing before drawing a conclusion.
Try both cases in the current ratio and quick ratio tools. Then change the collectibility assumption and explain why the interpretation changes even if the original arithmetic does not.
Make the numerator and denominator compatible
Use net credit sales for a receivables-turnover calculation where available, rather than assuming cash sales create customer receivables. Use COGS with inventory measured at cost for the standard inventory-turnover relationship. Match the period covered by the activity figure with the balances being analysed.
Average balances can be more representative than closing balances when a period’s revenue or profit is compared with an asset base. A simple opening-and-closing average can still miss seasonal peaks. Record what you used.
Use comparisons with a reason
Compare the business with its own history, an appropriate budget and genuinely comparable organisations. Check accounting policies, business model, size, seasonality and exceptional events. A popular “ideal ratio” is not a substitute for those checks.
Some lending agreements define debt, earnings or debt service differently from a textbook. For contractual analysis, use the agreement’s definitions and obtain the required review. A generic calculator cannot establish covenant compliance.
Explain a movement with a short analysis note
- Observation: state which ratio changed and how it was calculated.
- Evidence: identify the balance or activity movement behind it.
- Possible explanation: distinguish a supported cause from a hypothesis.
- Next check: name the report, record or question that would resolve the uncertainty.
For example: “Collection days increased using the same calculation basis. The ageing report shows a larger overdue balance from two customers. We need to confirm whether those invoices are disputed before attributing the movement to weaker collection activity.”
Choose the relevant tools from the 100-calculator library, and connect ratio analysis with the profit-versus-cash example. The result becomes useful when you can explain both its calculation and its limits.
