Top 5 Accounting Ratios and What They Reveal About a Company’s Health
When it comes to evaluating a company’s financial well-being, numbers tell the story. But with mountains of data in financial statements, where should you begin? The answer lies in accounting ratios—simple calculations that distill complex financial information into actionable insights.
Whether you’re an investor, business owner, or financial analyst, these top 5 accounting ratios offer a quick yet powerful way to gauge a company’s performance and overall health.
1. Current Ratio (Liquidity)
Formula: Current Ratio = Current Assets / Current Liabilities
What It Reveals:
The current ratio measures a company’s ability to pay its short-term obligations with its short-term assets. A ratio above 1 generally indicates that a business can cover its current liabilities, which is a sign of liquidity and financial stability.
Healthy Ratio: Typically between 1.5 and 3
Red Flag: Below 1, suggesting possible liquidity issues
2. Debt-to-Equity Ratio (Leverage)
Formula: Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity
What It Reveals:
This ratio shows how much debt a company is using to finance its operations relative to shareholders’ equity. High levels of debt can increase risk, especially during downturns, while too little debt may indicate underutilization of financing options.
Healthy Ratio: Depends on industry, but usually below 2
Red Flag: High ratio can indicate financial instability or aggressive risk-taking
3. Gross Profit Margin (Profitability)
Formula: Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
What It Reveals:
Gross profit margin shows how efficiently a company is producing its goods or services. A higher margin means more money is left after covering the direct costs of production, which can be used for operating expenses, investment, or profits.
Healthy Margin: Varies by industry, but consistency over time is key
Red Flag: Declining margins may indicate rising costs or pricing pressure
4. Return on Equity (ROE)
Formula: ROE = Net Income / Shareholders' Equity
What It Reveals:
ROE indicates how effectively management is using shareholders’ equity to generate profits. A high ROE is generally a sign of a strong, efficiently run business.
Healthy Ratio: 15% or higher is often considered strong
Red Flag: Sudden drops or ROE driven by excessive debt
5. Inventory Turnover Ratio (Efficiency)
Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory
What It Reveals:
This ratio measures how often a company sells and replaces its inventory during a period. It provides insight into operational efficiency and demand for products.
Healthy Ratio: Depends on industry; higher turnover usually indicates strong sales
Red Flag: Low turnover may mean overstocking or sluggish sales
Final Thoughts
Accounting ratios are like the vital signs of a business. While no single ratio gives a full picture, together they can reveal whether a company is thriving, stagnating, or in trouble. The key is to understand what each ratio means in context—industry norms, historical performance, and current market conditions all matter.
Whether you're making investment decisions or managing a business, mastering these five ratios will help you read between the lines of financial reports and make smarter, data-driven choices.
Ready to dig deeper into financial analysis? Feel free to ask about other financial metrics or tools to assess company performance!