What is Financial Ratio Analysis?

What ratio analysis is for
Liquidity ratios

Financial ratio analysis divides one number from your financial statements by another, so you can compare results across periods and with other businesses. A ratio such as current assets divided by current liabilities says more than either number alone. Ratios fall into four groups: liquidity (can you pay bills due soon), solvency (can you meet long-term debts), efficiency (how well you use assets such as receivables and inventory) and profitability (how much of your sales turn into profit).

Billed publishes this page. The definitions below come from the open textbook Principles of Accounting, Volume 1: Financial Accounting (OpenStax), Appendix A: Financial Statement Analysis and section 6.1, both opened on October 29, 2026. This is general information, not accounting or tax advice; ask your accountant where judgment is needed.

What ratio analysis is for

OpenStax: "The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors." It groups ratios this way: "There are four main categories of ratios: liquidity, solvency, efficiency, and profitability."

Two related methods look at the statements without dividing them into ratios:

Horizontal analysis: "Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items."
Vertical analysis: "Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement."

Liquidity ratios

"Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash."

Current ratio = current assets ÷ current liabilities. OpenStax: "The current ratio considers the amount of current assets available to cover current liabilities."
Quick ratio = (cash + short-term investments + accounts receivable) ÷ current liabilities. "The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses." See liquidity and the quick ratio and working capital.

Solvency ratios

"Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future."

Debt-to-equity ratio = total liabilities ÷ total equity. "The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing." See the debt-to-equity ratio, the debt ratio and what equity is.
Times interest earned = operating income ÷ interest expense. OpenStax describes it as measuring the ability to pay interest on long-term debt from earnings before interest and taxes, which it treats as operating income.

Efficiency ratios

OpenStax: "Efficiency shows how well a company uses and manages their assets."

Accounts receivable turnover = net credit sales ÷ average accounts receivable. It shows the number of times in a period you collect your receivables. Average receivables are the beginning and ending balances added together and divided by two. See accounts receivable turnover.
Inventory turnover = cost of goods sold ÷ average inventory. "Inventory turnover measures how many times during the year a company has sold and replaced inventory." See the inventory turnover ratio.

Profitability ratios

"Profitability considers how well a company produces returns given their operational performance."

Gross margin = gross profit ÷ net sales. OpenStax: "Cost of Goods Sold is deducted from net sales to calculate gross margin." See gross profit and operating margin.
Profit margin = net income ÷ net sales. "Profit margin represents how much of sales revenue has translated into income." See net income.
Return on total assets = net income ÷ average total assets. "The return on total assets measures the company’s ability to use its assets successfully to generate a profit."
Return on equity = net income ÷ average equity. "Return on equity measures the company’s ability to use its invested capital to generate income."

Worked example: one year of ratios

The business and figures here are a sample, invented for this example. All its sales are on credit, and it's a sole proprietorship, so there's no income tax line.

Income statement for the year:

Net sales: $240,000.
Cost of goods sold: $96,000. Gross profit: $240,000 − $96,000 = $144,000.
Operating expenses: $108,000. Operating income: $144,000 − $108,000 = $36,000.
Interest expense: $3,000. Net income: $36,000 − $3,000 = $33,000.

Balance sheet at year end (beginning-of-year figures in parentheses):

Cash $25,000, accounts receivable $30,000 ($26,000), inventory $15,000 ($13,000) and prepaid expenses $2,000: current assets $72,000.
Equipment $88,000. Total assets: $72,000 + $88,000 = $160,000 ($140,000).
Current liabilities $40,000 and a long-term loan $30,000: total liabilities $70,000.
Equity: $160,000 − $70,000 = $90,000 ($80,000).

The ratios:

Current ratio: $72,000 ÷ $40,000 = 1.8.
Quick ratio: ($25,000 + $30,000) ÷ $40,000 = 1.375, or 1.4 rounded.
Debt-to-equity: $70,000 ÷ $90,000 = 0.78 (rounded).
Times interest earned: $36,000 ÷ $3,000 = 12 times.
Accounts receivable turnover: average receivables ($26,000 + $30,000) ÷ 2 = $28,000; $240,000 ÷ $28,000 = 8.6 times (rounded).
Inventory turnover: average inventory ($13,000 + $15,000) ÷ 2 = $14,000; $96,000 ÷ $14,000 = 6.9 times (rounded).
Gross margin: $144,000 ÷ $240,000 = 60%.
Profit margin: $33,000 ÷ $240,000 = 13.8% (rounded).
Return on total assets: average total assets ($140,000 + $160,000) ÷ 2 = $150,000; $33,000 ÷ $150,000 = 22%.
Return on equity: average equity ($80,000 + $90,000) ÷ 2 = $85,000; $33,000 ÷ $85,000 = 38.8% (rounded).

Reading them: each ratio means more next to the same ratio for last year, or for similar businesses, than on its own. If the current ratio was 2.1 last year and is 1.8 now, ask why current liabilities grew faster than current assets. If receivables turnover fell, check whether customers are paying more slowly.

Comparing ratios

With your own past periods. Use the same formulas and the same kind of period, such as a full year or a quarter, so the change reflects the business, not the method.
With other businesses. OpenStax notes that "while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions." There's no single good value for every business. Compare with businesses of a similar type and size, and ask your accountant what to compare against.
With your inputs checked first. Ratios are only as reliable as the statements behind them, so reconcile accounts and classify income and expenses the same way every period.

Where Billed fits

Billed publishes this page. Its financial reporting page says "Billed offers several built-in reports: Invoice Reports (paid, partially paid, and overdue), Expense Reports, Income vs Expense Reports, Top Selling Products, and Time Tracking Reports." Invoices from Billed's invoice software and expense records from its expense tracking give you sales, expense and receivables figures for a period. Working out the ratios from your financial statements, as in the example above, is something you do yourself or with your accountant.

When this guide isn't for you

This page covers the common ratios for small businesses. If a lender has set ratio requirements in a loan agreement, or you're preparing statements for investors or a sale, work with an accountant on how each ratio is defined and calculated.

Frequently Asked Questions

What are the main types of financial ratios?

OpenStax groups them into four categories: liquidity, solvency, efficiency and profitability. Liquidity ratios look at bills due soon, solvency ratios at long-term debts, efficiency ratios at how you use assets such as receivables and inventory, and profitability ratios at how much of your sales become profit.

How do you calculate the current ratio?

Divide current assets by current liabilities. For example, current assets of $72,000 and current liabilities of $40,000 give a current ratio of 1.8.

What is the difference between the current ratio and the quick ratio?

The quick ratio uses only highly liquid assets, such as cash, short-term investments and accounts receivable, and leaves out inventory and prepaid expenses. That makes it a stricter test of whether you can pay bills due soon.

What is a good financial ratio for a small business?

There's no single good value. OpenStax notes that the industry a business operates in changes how much each ratio outcome matters. Compare your ratios with your own past periods and with similar businesses, and ask your accountant what to compare against.

What is the difference between horizontal and vertical analysis?

Horizontal analysis, also called trend analysis, compares the same line items across periods. Vertical analysis compares each line item with another item in the same statement, such as each expense as a share of net sales.

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What Is Financial Ratio Analysis? A Simple Guide for Small Business