What is ratio analysis?

The raw material is the balance sheet and profit and loss for most ratios, the cash flow statement for repayment capacity, and the trial balance, BAS and management accounts for monthly or quarterly monitoring. ATO Small Business Benchmarks and ABS and RBA industry data supply the comparators.

Frequency follows purpose: daily or weekly cash and liquidity snapshots in retail and hospitality, monthly working capital, debtor days and margin checks, and quarterly or annual solvency and return-on-equity reviews. Before calculating anything, convert cash and accrual figures to the same basis, strip out non-recurring gains or expenses, and normalise owner's drawings, related-party loans and GST so the ratios reflect the trading business.

Liquidity ratios ask whether you can pay what falls due soon: the current ratio is current assets over current liabilities, and the quick ratio does the same with inventory taken out. Profitability ratios ask what you keep from each sale. Gross margin is gross profit over revenue, net margin is net profit after tax over revenue, return on assets is EBIT over total assets, and return on equity is net profit after tax over equity. Lenders often work on a pre-tax basis instead, so results are comparable across company, trust and sole trader structures.

Efficiency ratios show how hard the assets work: inventory turnover is cost of goods sold over average inventory, and debtor days is trade receivables over revenue times 365. Solvency ratios show how much of the business runs on debt: debt-to-equity is total liabilities over equity, and interest coverage is EBIT over interest expense. A current ratio above 1 means current assets cover short-term liabilities, and high interest coverage lowers default risk.

For lending decisions the focus is interest coverage, debt service coverage, the current ratio and debt-to-equity. Lenders often write these into covenants and stress test them for lower EBITDA and higher interest rates, while investors watch sustained return on equity and margin stability.

Ratios have limits. Different depreciation, lease and revenue recognition policies hurt comparability; one-off asset sales or settlements distort margins; annual ratios hide seasonal cash shortfalls; guarantees and contingent liabilities sit off the balance sheet, and AASB 16 brought most leases on to it, which lifted reported gearing without changing the business; and start-ups show negative margins that only make sense against start-up peers. When a ratio moves, ask whether the driver is operational, an accounting adjustment or timing.