Financial Ratios: Ultimate Guide to Optimize Your Business Decisions

Imagine your company is on the verge of a financial breakthrough, poised at the edge of success. Your financial statements look strong (at least you’re pretty sure), but after a few months, nothing happens. 

Naturally, you’re disappointed and unsure where your organization went wrong. That’s when you realize you need to dive deeper into your financial ratios because they can reveal the true health of a business. 

This scenario isn’t just plausible — it’s a reality for many businesses navigating the complexities of investments. 

Fortunately, you can leverage financial ratios in your business analysis for quantitative insights into your company’s performance and financial health. They serve as a universal language, guiding a wide range of stakeholders toward informed financial decisions. Discover the most important ratios for your company and how to interpret them to unearth your financial status and fuel your business decisions. 

What Are Financial Ratios?

Financial ratios are numerical values created from a company’s financial statements to provide a picture of its fiscal health and operational efficiency. They serve as powerful tools when analyzing the relationships between different components of your organization’s financial data and can be used to guide your decision-making. 

When evaluating your company’s financial health, ratios offer insights into its ability to meet short-term obligations and generate profit. They can also indicate how well your company can manage debt and efficiently utilize assets. By comparing these ratios over time, stakeholders can gain a better understanding of the strengths and weaknesses of the company's financial strategies. 

How Financial Ratios Guide Business Decision-Making

Financial ratios serve as strategic tools that guide decision-making, helping you make informed choices about your company’s money. In strategic planning, ratios provide actionable insights into profitability and resource utilization, which can help align business goals with financial performance. For investors, ratios inform decisions on capital allocation by assessing a company's financial stability and growth potential. 

By performing a comprehensive ratio analysis, your company can discover: 

• Growth potential. You could look at profitability ratios like the return on assets (ROA) or return on equity (ROE) to determine whether you need to reinvest profits in your company or if you’re able to pursue new investments and purchase additional assets for expansion. Armed with this information, you know where to put your money to continue growing as a company. 
• Operational inefficiencies. Efficiency ratios such as inventory turnover or accounts receivable highlight operational inefficiencies — like bottlenecks — that could be hindering your cash flow. By identifying these, you’re able to reduce the holdups and boost productivity. 
• Financial stability. Your liquidity ratios, like the current ratio, tells you if you can meet short-term obligations. If you’re able to, you can be assured your organization is stable, while a poor ratio would show that you need to take steps to stabilize your finances. 

For example, according to Amazon’s end-of-year 2023 data, the company had a cost of revenue of $387,831,000K and an inventory cost of $33,318,000K. That gave the organization an inventory turnover ratio of 11.64, which means it’s selling out its inventory around every two months. Using this information, Amazon can determine that it is operating efficiently as it’s able to meet customer demands quickly and restock its inventory multiple times throughout the year. 

Financial ratios are most useful for businesses over time. Looking at one quarter can help you make decisions for the next, but a full calendar year and multiple ratios can help you paint a holistic picture of your financial situation — and pinpoint the best spots for improvement.

Types of Financial Ratios

The five types of ratios offer a comprehensive view of the company’s monetary health. On their own, they each serve a unique purpose, such as measuring financial risk and market valuation. However, analyzing a combination of these ratios will provide a more holistic view of your business’s performance and prospects. 

Liquidity Ratios

This type of ratio is used to assess a company’s ability to meet short-term obligations with its current assets. Common liquidity ratios include the current ratio which measures your ability to pay off debts and the quick ratio, which indicates if you could pay off your liabilities with your assets. A higher liquidity ratio indicates a stronger ability to cover short-term debts, which reassures creditors and investors about the company's financial health.

For example, you could calculate how much cash your assets would provide and compare that to your current liabilities to find your quick ratio. If the value is higher than one, you’re likely in a good spot financially, but if it’s less than that, you may need to raise capital. 

Leverage Ratios

A leverage ratio focuses on the debt levels and capacity to meet long-term obligations. Examples include the debt-to-equity ratio which compares how much of your funds come from borrowing and from investors and the interest coverage ratio, which shows how well you can pay on outstanding debts. Both of these ratios provide insights into a company's financial risk and its reliance on debt financing. High leverage may amplify returns, but it also increases the risk of financial distress.

If you have $15 million from your shareholders and $10 million from your loans, you would have a debt-to-equity ratio of 0.67 — which is likely acceptable in most industries because you would be able to pay off your borrowed money with the shareholder investments. 

Efficiency Ratios

You can use efficiency ratios to evaluate how well your company utilizes its assets to generate sales and manage resources. There are a few different ratios within the category of efficiency, including inventory turnover (which measures how many times your inventory is sold and replaced) and accounts receivable turnover (that illustrates how well your company collects customer debts). They help assess operational efficiency, which then identifies areas for improvement in revenue generation. 

Your company probably wants to aim for an accounts receivable ratio of 10 to 15%, where only a few of your customers still owe you money. However, the exact ideal ratio may vary depending on your specific circumstances. For example, a small company with only a few hundred customers may want to aim for a lower ratio since they have fewer assets to cover these expenses. 

Profitability Ratios

This ratio type gauges an organization’s ability to generate profits relative to its revenue or equity. Key profitability ratios include net profit margin, return on assets (ROA), and return on equity (ROE). All three of these ratios provide a comprehensive view of a company's ability to translate sales into profits.

For example, the ROA shows how much profit your company generates from your assets. The goal is to have a ratio that’s five percent or higher, though that can vary, so you’re generating adequate revenue from your assets. 

Market Value Ratios

The final category of financial ratios reflects investor sentiment and market perception of a company’s prospects. This includes things like the price-to-earnings ratio and earnings per share, which divide net earnings available to shareholders by the average value of the shares. Market value ratios help determine whether a company is under or overvalued in the stock market. This helps investors make decisions based on the market expectations and the earnings potential of your company.

For instance, your price-to-earnings ratio compares your share price to what you earn per share. A good ratio would be around 20 to 25 or lower, while a higher ratio would indicate that you could be overvalued. 

Interpreting Financial Ratios

One ratio on its own can give you some information, but one number can’t show you the big picture. A holistic analysis of various ratios within the context of industry benchmarks and your company's strategic goals can give you a comprehensive understanding of your business’s financial health. To help you piece together your ratio profile, these are some of the ways you could interpret the results of your calculations. 

Liquidity Ratios

These help assess a company's ability to cover short-term obligations. A high current ratio, above one, suggests this is easy, but an excessively high ratio may point to inefficient resource utilization. On the other hand, the quick ratio indicates immediate liquidity and is considered good when it’s close to one. 

Leverage Ratios

This ratio focuses on your organization’s capability to meet long-term debt obligations. For example, a high debt-to-equity ratio — above two — signifies heavy reliance on debt financing, potentially increasing risk. Conversely, a low ratio — under one — may indicate underutilization of leverage and potential operational issues. An interest coverage ratio below one may signal challenges in meeting interest payments while one higher than two is a good sign for your company’s financial health. 

Efficiency Ratios

Efficiency ratios evaluate resource management, so high inventory and accounts receivable turnover ratios — usually between five and 10 — indicate efficiency. However, low turnover (less than five) may suggest overstocking or credit issues. Total asset turnover reflects how well assets generate revenue, with a higher ratio indicating better efficiency.

Profitability Ratios

These metrics show how much your company is making. For instance, a high net profit margin signals effective cost management, while a low margin may indicate operational challenges. Return on assets and return on equity demonstrate efficiency in generating profits relative to assets and equity, respectively. The goal is to have a value over five percent, and the higher the better — that shows how much profit your company can generate. 

Market Value Ratios

This category of ratios helps show investor sentiment and potential opportunities for growth. A high price-to-earning ratio — above 30 — may suggest growth expectations or an overvalued stock, while one lower than 20 could indicate your company is a good investment. Comparing price-to-earnings ratios with industry peers provides contextual valuation, while earnings per share gives a per-share view of profitability.

While these examples can give you a general idea of what is considered good, consider comparing each of your ratios with your competitors. Putting these numbers in context helps you identify what’s normal and promising for your field. For example, a technology company often has gross margins higher than 90%, which is often too high for other industries but perfect for that industry. Putting all of these ratios together and comparing them to the right metrics can help you determine your company’s financial health and make decisions based on data.

Calculating Key Financial Ratios

Here's how to calculate some of the most common financial ratios step-by-step:

Debt-to-Equity Ratio

This ratio measures a company’s reliance on debt versus equity to finance operations and can be calculated with this formula: Debt-to-Equity Ratio = Total Debt ÷ Shareholders’ Equity

If a hypothetical company has $500,000 in total liabilities and $250,000 in shareholders’ equity, the calculation would look like this: Debt-to-Equity Ratio = 500,000 ÷ 250,000 = 2

This company has two dollars of debt for each dollar in equity — which is the highest you would want to let this ratio get. Except for industries like manufacturing and mining, most companies aim to keep this lower than two, so this company will likely try to reduce its debt or increase its equity within the next year. 

Current Ratio

By using this ratio, you can assess your company’s ability to pay short-term obligations with short-term assets:  Current Ratio = Current Assets ÷ Current Liabilities

An organization with $300,000 in assets and $150,000 in liabilities would calculate the current ratio as such: Current Ratio = 300,000 ÷ 150,000 = 2

The results show this company has twice the assets needed to cover its liabilities, which in most ratios is sufficient. A ratio less than one might indicate financial instability since you wouldn’t have enough capital to cover your liabilities. 

Return on Equity (ROE)

Using ROE, you can evaluate how effectively your company generates profit from shareholders' investments with this formula: Return on Equity = Net Income ÷ Average Shareholders’ Equity

This example company generates $100,000 in net income for the year and its shareholders have $400,000 in equity. That gives the business these results: Return on Equity = (100,000 ÷ 400,000) x 100 = 25%

This means the company generates a 25% return on shareholder investments, which is extremely high. Most organizations aim for 15–20%, but for most industries, the higher the ROE ratio, the better. 

Gross Margin

The gross margin ratio measures profitability by showing how much revenue remains after covering production costs. It’s calculated like this: Gross Margin = ((Revenue - Cost of Goods Sold) ÷ Revenue) x 100

A hypothetical organization currently makes $1,000,000 in revenue and makes $600,000 from its products, which gives it a gross margin of: Gross Margin = ((100,000 - 600,000) ÷ 1,000,000) x 100 = 40%

A gross margin of 40% indicates that almost half of the company’s revenue is retained as profit before other expenses, which is likely lower than what the business needs. This organization would then try to increase its COGS through the next year. 

Earnings per Share (EPS)

This ratio indicates profitability on a per-share basis with this formula: Earnings per Share = (Net Income - Preferred Dividends) ÷ Average Number of Shares Outstanding

An example of this in action is a company with $500,000 in net income for the quarter and $100,000 in outstanding shares. That gives the organization this ratio: Earnings per Share = (500,000- 50,000) ÷ 100,000 = 4.5

This means each share earns $4.50 in profit, which the organization can then compare to its competitors to see how it’s performing in the market. 

Financial Ratios Cheat Sheet

This quick reference for essential financial ratios can help you accurately determine your company’s major ratios and begin putting together a full financial analysis: 

Liquidity Ratios

• Current Ratio = Current Assets ÷ Current Liabilities
• Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities

Leverage Ratios

• Debt-to-Equity Ratio = Total Debt ÷ Shareholders’ Equity
• Interest Coverage Ratio = Earnings Before Interest and Taxes ÷ Interest Expense

Efficiency Ratios

• Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
• Accounts Receivable Turnover = Net Sales ÷ Average Accounts Receivable
• Total Asset Turnover = Net Sales ÷ Average Total Assets

Profitability Ratios

• Net Profit Margin = Net Profit ÷ Net Sales
• Return on Assets = Net Income ÷ Average Total Assets
• Return on Equity = (Net Income ÷ Average Shareholders’ Equity) x 100

Market Value Ratios

• Price-to-Earnings Ratio = Market Price per Share ÷ Earnings per Share
• Earnings per Share = (Net Income - Preferred Dividends) ÷ Average Number of Shares Outstanding

How to Avoid Common Pitfalls in Using Financial Ratios

Interpreting financial ratios requires careful consideration because a misguided assessment could lead to negative financial consequences. 

One common mistake is misinterpreting industry benchmarks and using them to make business decisions. For example, a high debt-to-equity ratio might be typical for capital-intensive industries like utilities or manufacturing but could be a red flag in a service-based business. Since different industries have varying norms and standards, consider finding or calculating three to five of your competitors’ ratio profiles. This can give you insight into your specific industry and help you use the right metrics to make decisions. 

Another error is relying solely on a single ratio without considering the broader financial context. A seemingly strong ratio in isolation may not accurately reflect overall financial health because it’s only one piece of the puzzle. For example, neglecting factors like changes in management or shifts in market dynamics can also lead to oversights. Instead, consider analyzing a mix of ratios across multiple categories (like liquidity and market value) to build a comprehensive picture. 

Using Financial Ratios in HR Practice

In addition to fueling business decisions, your HR team can glean valuable information from your company’s ratio profile. These are some areas where a comprehensive financial profile could affect HR: 

• Compensationand benefits planning. Understanding your company’s financial situation via ratios can help you make important decisions about salary adjustments and bonuses. If your ratios show promise of future growth, you can discuss raises and large bonuses with your leadership team while you might have to make cuts if the numbers are off. This information can also help you plan your benefits budget.
• Workforce planning. If your ratio profile indicates growth, that can prepare your team to begin expanding your workforce — and vice versa. These numbers can also help pinpoint workforce cost inefficiencies where you could cut down on expenses to help improve your liquidity or returns. 
• Employee retention. Sometimes your company’s financial situation could be affecting your turnover rates. For example, if your ratios show financial instability, your company might not be investing in employee development to save money. However, a lack of these opportunities could be a top contributor to turnover — and losing employees is likely only hurting your company. This information could help you gain support for building a stronger training and development program for your workers. 
• Strategic planning. When your team understands financial ratios, you’re better able to align your strategies with the organization’s goals. You can make strategic decisions — like expanding your benefits offerings to boost retention — that can ultimately help the company run more efficiently. 

Financial Clarity Starts with Employee Wellbeing

Financial ratios offer a clear lens into your company's fiscal health, helping you pinpoint opportunities for growth and stability. But the most robust financial strategies can falter without a healthy, engaged workforce.

Investing in employee wellbeing programs like Wellhub supports your team’s productivity and engagement, which directly impacts profitability. Companies with active wellbeing initiatives see up to a 35% drop in healthcare costs and 43% reduction in turnover, fostering both financial and operational stability​​. Enhanced employee wellbeing not only boosts morale but also strengthens your ability to make informed, data-driven business decisions by aligning a thriving workforce with strategic goals.

Speak with a Wellhub Wellbeing Specialist to ensure your workforce is equipped to drive both short-term profitability and long-term financial growth.

You May Also Like:

• An HR Leader’s Guide to Key Performance Indicators
• Eight KPIs for Payroll that HR Can Track
• 10 Crucial DEI Metrics to Track for Improved Workplace Inclusion

References

• BDC. (n.d.). Gross profit margin. https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/gross-profit-margin-ratio
• Reeves, M. (2024, October 24). Lack Of Career Growth May Be The Top Cause For Turnover In 2025. Forbes. https://www.forbes.com/councils/forbeshumanresourcescouncil/2024/10/24/lack-of-career-growth-may-be-the-top-cause-for-turnover-in-2025/