Financial Ratios
Liquidity and leverage ratios from a balance sheet, computed together.
Current assets ÷ current liabilities. Around 1.5–3 is typical; below 1 means short-term obligations exceed short-term resources.
The same test with inventory stripped out, since inventory can be slow or impossible to sell at book value. Around 1 is the usual benchmark.
The cash ratio is the strictest liquidity test. Working capital is the absolute cushion in currency rather than a ratio.
0.67 of debt for every 1 of equity, funding 40% of assets. What counts as high is industry-specific — utilities carry far more than software firms.
EBIT ÷ interest — how many times over operating profit covers the interest bill. Below about 1.5 leaves little room for a bad year.
Ratios mean little in isolation. Compare against the same firm over time and against direct competitors — a current ratio of 1.2 is normal in retail and alarming in heavy industry.
Liquidity ratios ask whether a firm can meet its short-term obligations. With 500 of current assets — 180 of it inventory — against 250 of current liabilities, the current ratio is 2.0 and the stricter quick ratio is 1.28.
Two questions, several angles
Balance-sheet ratios answer two distinct questions. Liquidity ratios ask whether the firm can pay what falls due in the next year. Leverage ratios ask how much of the business is funded by debt rather than equity, and whether profits comfortably cover the interest.
Within liquidity there is a ladder of strictness. The current ratio counts every current asset. The quick ratio removes inventory, on the reasoning that stock is the hardest current asset to convert quickly and may not fetch book value in a hurry. The cash ratio counts only cash — the test a firm would face if credit dried up entirely.
Interest coverage is the one to watch
Of all these, interest coverage is often the most informative, because it connects the balance sheet to the income statement. A debt-to-equity ratio of 2 tells you the firm is leveraged; interest coverage tells you whether that leverage is actually a problem. A firm covering its interest eight times over can carry substantial debt safely, while one covering it 1.2 times is one bad quarter from trouble regardless of how the balance sheet looks.
CA is current assets and CL current liabilities. Working capital is CA − CL, an absolute cushion rather than a ratio.
Worked example
The same balance sheet read through each lens:
- 1 Start with the current ratio. 500 current assets ÷ 250 current liabilities = 2.0. Comfortable by most standards.
- 2 Strip out inventory. (500 − 180) ÷ 250 = 1.28. Still above 1, so the firm could cover its obligations without selling stock.
- 3 Count cash alone. 90 ÷ 250 = 0.36. Cash alone covers about a third of short-term obligations, which is normal.
- 4 Take working capital. 500 − 250 = 250 in absolute terms — the cushion in currency rather than as a multiple.
- 5 Look at leverage. 400 debt ÷ 600 equity = 0.67, funding 40% of the 1,000 total assets.
- 6 Check the coverage. 150 EBIT ÷ 30 interest = 5.0×. Operating profit covers interest five times over.
Rules of thumb, and what they hide
These benchmarks are starting points only. Every one of them is industry-dependent.
| Ratio | Often quoted as healthy | The caveat |
|---|---|---|
| Current ratio | 1.5 – 3.0 | Very high can mean idle cash or bloated stock |
| Quick ratio | Around 1.0 | Retailers run far lower and are perfectly sound |
| Cash ratio | 0.2 – 0.5 | Rarely a concern on its own unless credit is tight |
| Debt-to-equity | Below 1.0 – 2.0 | Utilities carry far more; software firms far less |
| Interest coverage | Above 3× | Below about 1.5× leaves no room for a bad year |
Ratios in isolation say almost nothing
A single ratio from a single year is close to meaningless. The value comes from two comparisons: the same firm over time, where a current ratio drifting from 2.0 to 1.1 across three years is a signal regardless of where it started, and the firm against direct competitors, since what is normal varies enormously by industry.
Supermarkets routinely operate with current ratios below 1 because they collect cash at the till and pay suppliers on extended terms — a position that would be alarming in heavy manufacturing. Utilities carry debt levels that would frighten a software company's investors, and rightly so, because their revenues are regulated and predictable.
Be aware too that ratios can be managed. A firm can improve its year-end current ratio by delaying purchases or accelerating collections in the final weeks, a practice sometimes called window dressing. That is one more reason to read a trend rather than a snapshot.