Using financial ratios in business helps you understand how your business is performing beyond the headline numbers. A profit figure, cash balance or sales total can tell you something, but ratios help you compare, question and interpret those numbers. They can show whether profit is strong, cash flow is under pressure, assets are being used well, or risk is increasing.

This episode is for business owners, managers, charities, arts organisations and social enterprises who want to get more meaning from their financial statements. We look at what ratios are, where the information comes from, the four main areas of ratio analysis, and the limits of using ratios on their own.

About this episode

Numbers are not just there to sit in a report. Every sale, purchase, wage payment, freelancer cost, success, problem and business decision eventually feeds into your financial statements.

Financial ratios help us take those figures and turn them into something more useful. Instead of looking at isolated numbers, we compare one number with another to understand what is really happening.

In this episode, we explain ratio analysis in plain English. We look at the source documents behind the numbers, the main areas that financial people examine, and why ratios need context before we make decisions from them.

Why financial ratios matter

Financial ratios matter because they help us make sense of business performance. A number on its own can be useful, but it does not always tell the full story.

For example, a profit figure of £50,000 may sound good. However, that number becomes more useful when we compare it with sales. If sales are £200,000, then profit is 25% of sales. That percentage gives us a clearer way to understand performance.

Ratios also help us compare performance over time. We can look at this year against last year, compare different parts of the business, or benchmark against other organisations where suitable information is available.

For a wider foundation, our episode on understanding your financial statements explains how the profit and loss, balance sheet and cash flow statement work together.

Key points from this episode

What is a financial ratio?

A ratio is a relationship between two or more numbers. In business, financial ratios help us compare figures so we can understand performance more clearly.

Ratios can be shown as percentages, fractions or simple numbers. The format matters less than the insight we get from the comparison.

For example, if your business makes £50,000 profit from £200,000 of sales, that tells us profit is 25% of sales. That is more useful than looking at the profit figure alone.

Where the information comes from

Financial ratios usually come from the main financial statements. These are the profit and loss account, the balance sheet and the cash flow statement.

The profit and loss account shows sales, expenses and profit over a period of time. It helps us understand whether the business made a profit or loss.

The balance sheet is a snapshot at a point in time. It shows what the business owns, known as assets, and what it owes, known as liabilities.

The cash flow statement shows money moving in and out of the business. It connects the dots between trading activity, spending, cash in the bank and business survival.

Understanding the language in these reports is important. Our guide to financial terminology for business owners explains terms such as profit, operating costs, assets and balance sheets in more detail.

Profitability ratios

Profitability ratios help us understand whether the business is making enough profit from its activity.

Gross profit margin is one common example. It compares gross profit with sales and shows how much is left after direct costs are taken away.

Net profit or operating profit margin looks further down the profit and loss account. It shows what remains after overheads and support costs have also been considered.

These ratios matter because profit helps build reserves, reward effort, support the team and create a more sustainable business.

Efficiency ratios

Efficiency ratios look at how well the business uses its resources.

This is not about judging how hard one person works. It is about asking whether the assets, stock, people, space and systems in the business are being used well to create value.

For example, a retailer or manufacturer may look at how quickly stock turns into sales. Another business may look at profit per staff member, profit per square metre, or sales generated from available assets.

Liquidity ratios

Liquidity means access to cash. A business may appear profitable but still struggle if cash is tied up in stock, customer accounts or slow payments.

Liquidity ratios help us look at whether the business has enough cash or near-cash resources to meet its commitments.

One useful measure is debtor days, also called receivable days. This looks at how long customers take to pay after receiving an invoice. The longer that figure grows, the more pressure it can put on cash flow.

Cash matters because without it, even a profitable business can face serious problems.

Risk and return ratios

Risk and return ratios look at the reward generated from the risk taken in the business.

Every business carries risk. The important question is whether the return is strong enough for the level of risk involved.

This area can be useful for business owners, investors and decision-makers who want to understand whether the business is generating enough value from the money, time and resources invested.

Why ratios need context

Ratios can be powerful, but they are not perfect. We should not use them in isolation.

Good ratio analysis needs context. We need to look at trends, compare like with like, and consider whether the financial statements are reliable.

Technology and accounting software can produce many ratios quickly. However, more numbers do not automatically mean better insight. The real value comes from choosing the right ratios, asking better questions and understanding what the figures are telling us.

FAQs about using financial ratios in business

What are financial ratios in business?

Financial ratios compare two or more numbers from your business accounts. They help you understand performance, profit, cash flow, efficiency and risk more clearly.

Why are financial ratios useful?

Financial ratios make large numbers easier to understand. They help you compare performance over time, spot trends and ask better questions about your business.

What financial statements are used for ratio analysis?

Ratio analysis usually uses figures from the profit and loss account, balance sheet and cash flow statement.

Should financial ratios be used on their own?

No. Financial ratios should be used with other information, including trends, business context, reliable records and your own knowledge of what is happening in the business.

Episode Timecodes

• 00:00 – Why business owners need to understand performance
• 00:27 – Source documents and key areas of ratio analysis
• 01:18 – Mahmood’s background and purpose of the episode
• 01:48 – How business activity feeds into the numbers
• 02:21 – What a ratio means
• 03:00 – Profit and sales ratio example
• 04:16 – Why ratios help make numbers more manageable
• 04:52 – The three main financial statements
• 05:40 – Profit and loss account explained
• 05:40 – Balance sheet explained
• 06:51 – Cash flow statement explained
• 07:30 – Four key areas of financial ratio analysis
• 08:02 – Profitability ratios
• 08:41 – Efficiency ratios
• 09:08 – Liquidity and cash availability
• 09:48 – Risk and return
• 10:21 – Gross margin example
• 12:09 – Using assets efficiently
• 12:49 – Debtor days and cash flow pressure
• 14:26 – Limitations of financial ratios
• 15:01 – Final recap

Related episodes

• Understanding Your Financial Statements: Cash Flow, Profit and Balance Sheet
• Understanding Financial Terminology: Capital Expenses, Operating Costs and Profit
• What Is Profit? Gross Profit and Net Profit Explained

Key takeaway

Using financial ratios in business helps us turn raw numbers into useful insight. Ratios can show how profitable the business is, how well resources are being used, how strong cash flow looks, and whether risk and return are balanced.

The key is not to calculate ratios for the sake of it. Use them to spot trends, ask better questions and make stronger decisions. Ratios are most useful when we combine them with reliable financial statements, business context and practical judgement.

Plan it, Do it, Profit.

“Financial ratios help us turn raw numbers into insight, so we can understand performance and make better business decisions.”

Further Support

The I Hate Numbers podcast helps business owners understand accounting, tax, finance, profit, cash flow, and business planning in a practical way. We simplify financial topics so you can make better decisions and feel more confident with your numbers.

You can also watch more practical finance and business support on the I Hate Numbers YouTube channel, or listen and follow on Apple Podcasts.

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If you are running a business, if you're managing a business, it's critical that you understand how your business is performing. A common technique that is adopted to help understand how the financial performance is doing is to use a technique called ratio analysis. In this podcast, I’m going to dive in and explain the technique of ratio analysis. We're going to be discussing the source documents. Where does that information come from?

So we're going to have a look under the bonnet of the three primary financial statements. I'm going to talk about the four key areas that financial people, financial analysts, tend to look at when it comes to understanding, reviewing and comprehending financial performance. And I'm also going to be mentioning the limitations of this technique as well.

You're listening to the I Hate Numbers podcast with Mahmood Reza. The I Hate Numbers Podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

Hi, folks. My name is Mahmood, and welcome to another weekly episode of I Hate Numbers. My background: I'm an accountant, I'm an educator, and I'm the proud author of the book I Hate Numbers. I've been an accountant for over 27 plus years, running my own businesses, and I've helped thousands of businesses, private, arts and social and charities over the years to get closer to their numbers, reduce the anxiety they face, and help them navigate towards a business future they aspire to.

I'd love it if you folks could subscribe to this podcast. Give me your feedback if you like it. If you don't like it, let me know why. Let's crack on with the podcast now, numbers. Let's get some sanity check here. The figures that we see in the financial statements, more of that in a second or two, fundamentally reflect the activity that your business is going through. So every time you buy something, every time you sell something, every time you engage and pay for a freelancer, pay for wages of your staff, every time something goes wrong,

every time something succeeds, ultimately that will feed through and be captured in the numbers of your organisation. Those transactions will be recorded. Those transactions will then be used to help generate the three financial statements, typically, that a lot of organisations will be generating. Now, before we dive into what those statements are, before we look at the areas that ratios will look at, let's first of all understand why ratios are used in the first place. Now, just as a flashback to the understanding of the term ratio, a ratio is just a relationship between two or more numbers.

For example, if I generate a level of profits of, say, £50,000, that is a number in itself and that's what mathematicians would call an absolute number. It's the figure. If, however, I want to get some more meaning out that £50,000, I might relate that to perhaps how much I've generated by way of sales, by way of turnover. So using that same level of profitability, if I've generated a turnover of £200,000, then I can say out of that £200,000 worth of sales, I've generated a profit of 50,000. So if I divide one by the other, that gives me a 25% figure

i.e. of that sale, 25% is the profit that I've generated. What we've just done there, we've calculated a ratio. A ratio can be expressed in percentage terms. It can be measured and expressed as a raw number, it can be expressed as a fraction. Anyone remember those? I certainly do. So a ratio is just a relationship between two numbers. Now, you might be thinking to yourself, well, why do we bother with ratios? Well, one of the main benefits of ratios is it can condense lots of numbers that might make our head hurt.

If we look at a sheet where we got numbers coming from all over the place, we look at our financial statements here, we want to try and get some meaning. So we relate one thing to another and we make an effective relationship. First of all, it condenses all those big numbers to something that's more visible, more manageable. Secondly, we can use those figures to compare against previous years, against other organisations that we might have access to data on, and ratios will condense and able us to give much better insights. There are obviously limitations, which I'll address towards the end of this podcast.

The next thing I want to address and talk about is what's the source of the information where analysts, numbers, people and yourself will access to actually help us calculate the ratios. Later on in the podcast, I'm going to discuss and mentioned the four key areas that most financial analysts tend to look at when they analyse the performance and understand the performance of a business. The three primary documents that are used are the profit and loss. For those jargon people out there, profit and loss is one term that's expressed. You can call it a P&L, you can call it an income and expenditure, and that is a document that summarises effectively the level of sales activity that your business has undergone, what the related expenses are,

and the primary performance measure that comes out of that is the profit. And a profit or loss account is fundamentally a performance statement measuring how well a business has done over a period of time. Statement number two is what's called a balance sheet. Now, a balance sheet is purely a statement. It's a snapshot in time, it's a freeze frame. Say, if I made a list, if I represented this as a see-saw on the left hand side of my see-saw, I'm going to list all the items of value in my business, what we may call assets. So things like equipment, machinery, fixtures, fittings.

If you happen to own a building as well throw that into the mix as well. On the right hand side of the seesaw, I'm going to position and make a list of all the debt that I have, the more depressing side of your business. So there could be loans, overdrafts, mortgages, monies owed to suppliers and that will give you your debt. And again, if you want a bit of technical terminology here, you may express that as liabilities. Now, if they balance themselves out perfectly, which is very unlikely, that means your business at that point has no monetary value overall.

What we typically expect is that the assets, as we call them, are going to outweigh the liabilities. There's a link in the show note, folks, by the way, for a previous podcast where we've looked at those financial statements. The last financial statement that you are likely to be looking at is what's called the cash flow statement. And that connects the dots, that shows the flow of hardcore cash flowing in through the company's bank accounts. The money coming in and the money going out, and that will be from selling things, goods and services, surplus assets. It will be detailing the money that goes out in cash. So whether that’s buying equipment, paying suppliers,

paying for operating costs, paying yourself and the like. So what have we covered so far? We've looked at the idea of ratios, we've looked at what they can lend to us or they can give us. We look to the financial statements from which this data is extracted. Now, let's have a look at the key areas that financial analysts and numbers people tend to look at when they analyse the performance of a company. The four key areas that are examined are typically profitability, efficiency, liquidity and what's called risk and return.

Now, bear with me as we explore each one of these in turn. Now, profitability is a very popular measure and anyone in business, whether that's a private business, arts or social, should aspire to be making a return to making a profit in their business. So whatever your’re incurring by way of costs to deliver to your end customers, to support your business, you need to recoup those costs and have something on top to compensate you for your time, your energy, to help build up reserves and to reward yourself and your team. So profitability is a key measure.

Now, efficiency, it's not saying about you necessarily as an individual how efficient you are, it's saying of all the resources you have at your disposal, your assets if you wish, how efficiently are they being used to generate value? How efficiently are they being utilised in your business? The third number we're going to comment on here is what's called liquidity. And liquidity is just an alternative term for saying the availability of cash.

It's a fundamental truth that if your business does not have access to cash resources, if your business does not have cash in the bank, does not have those facilities there, then it's going to be very, very difficult for it to survive, let alone prosper. Ultimately, a lack of cash, a lack of access to cash means that your organisation is likely to face big challenges, which pretty much will mean that's the end of the road for your business. So liquidity is a key item. And the last area that we look at is what's called risk and return. All business owners will incur a level of risk by nature. Nothing in life is risk free.

There will always be a risk in running a business. And what we are thinking about is if we undertake that risk, if we go into our business incurring the risk, and all businesses have different levels of risk, what's the return that's likely to be generated as a result? Now, typically, in those four metrics here, we can have a bunch of ratios that we can calculate. And the key thing to remember here, folks, is under these umbrellas - this is just a general framework here - if you're using these numbers internally, you need to adapt them for your particular circumstances.

So if I take as an example the area of profitability, the two most common measures used in profitability are to measure the level of gross margin or gross profit. That's the profit that you generate from your goods and services that you're supplying, less any costs that are matched and more immediately against them. What does that mean? So if I'm a retailer selling stock, I will look at the cost of an item, let's say £10. If I sell that for 30, I've made a gross margin of £20. In ratio terms, the gross margin would be effectively two thirds, which is just approximately 67%.

That would be my gross margin percentage. That is the ratio. The original numbers that I've expressed earlier, those are the figures expressed in power notes. What I'm looking for is to get that in terms of percentages and a ratio. Now ultimately, the gross margin is there to help feed in and cover the support costs. Typically, you might call them overheads, things like the rent, wages to your team, delivery and the like, marketing, PR, HR, IT… you know, add your own items in there to make up that list.

Once we've covered all those, then we have what's called a net profit. You may also come across it is called an operating profit or operating margin. Now, in terms of adapting that, you may want to then measure the profitability in relation to your own business. So what's the profit perhaps, per staff member? What's the profit perhaps per square meterage? If you've got a facility, if you've got a shop, you might want to measure the profits that you're generating on those here. You might want to measure it in terms of per customer. Adapted, by all means, but here we're just talking about the general framework.

The efficiency is just that. It's saying, how well do we use the assets at our disposal. Typically efficiency, if you are, say, a manufacturing business or a retailing business, you might want to say how quickly can I empty my store, get it converted into a sale to my end customer? So the ability to turn that round, how effectively all my assets, generating value, generating turnover and those might be areas that I look at there. Now, liquidity is not just cash in the bank that we mentioned earlier, that's really important. We tend to, especially if we are selling things, have monies wrapped up, tied up in inventory.

If we offer credit facilities to customers, again, that's a strain on the cash flow and it's a true system. Every time we offer credit facilities to a customer and they take them, that means there's a negative impact on our own cash flow. We look at how much money is tied up in customer accounts, how much money is tied up in the inventory. We don't just look at the actual physical amount, which is important, but we actually look at that in terms of ratios. We might measure things called receivable or debtor days.

How long does it take our customer to pay us for the date they get the invoice? Obviously we're looking for a smaller figure as possible so that the bigger that goes up and it's measured typically in days, the more problems we are likely to face. Likewise, when we buy inventory for resale, we buy in raw materials to convert it into a product. That's money that's tied up in those items. Until we actually get it out the door, sell it and get the cash from a customer, that's money tied up and that's a big impact potentially on our cash flow.

Risk in return would be looking from an investor's perspective, how much are they likely to get from the investment they are making in their business, in your business? Now, if we look at those four quadrants together, that will give us a bunch of numbers and there's a few things that is worthwhile mentioning here before we start to wrap up the podcast. Now, we can quite easily with technology, with our accounting software, accounting systems, tapping into the financial planning story planning community, that is Numbers Know How, link in the show note folks there, by the way, we can calculate numbers till they come out of our ears.

However, that's not going to help us much in understanding performance. What we need to do is to be aware and we're looking at things like trends, we're looking to make sure we are comparing like for like we need to take into account the relevance and reliability of those numbers. The credibility of your financial statements is going to have an impact obviously then of the ratios that are calculated. In next week's podcast, I'm going to go through a worked example specifically looking at an organisation, I'll publish the case study within the show notes and we can then draw out some more meaningful conclusions.

Folks, I hope you got some value from this particular podcast today. What have we looked at? We've looked at the power of ratios. We've looked at the typical areas that are examined by financial ratios. We looked at the source documents that those numbers are extracted from, and we've also added a cautionary note about the limitations on financial ratios as well. I hope you've got some value out this podcast. If you have, obviously I'd love to hear your feedback. I'd love it even more if you could leave a comment or perhaps share that with friends or colleagues. Until next week, folks, have a good week.

We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.