Profitability ratios and liquidity ratios: formulas, two years worked through, and how to read them

Profitability ratios measure how much profit a company makes from its sales and from the capital it uses: margins divide profit by revenue, and returns (ROA, ROE, ROCE) divide it by assets, equity or capital employed. Liquidity ratios measure whether it can pay what falls due within a year: current assets, or the quicker part of them, over current liabilities. On the distributor below, revenue grew 9.7% in a year while every profitability ratio fell and the quick ratio dropped below 1.0.

Financial ratios: the four families

The CFA Institute's reading on financial analysis techniques groups ratios by the question they answer:

This page covers the first two in depth. Each ratio is kept short here; the single-ratio pages go further.

Profitability ratios and their formulas

Gross margin = Gross profit / Revenue

Operating margin = Operating profit / Revenue

Net margin = Net income / Revenue

ROA = Net income / Total assets

ROE = Net income / Shareholders' equity

ROCE = Operating profit (EBIT) / (Total assets − Current liabilities)

The three margins answer how much of each sales dollar survives each layer of cost: cost of sales, then operating expenses, then interest and tax. Operating margin and net profit margin each have their own page.

The three returns answer how hard the capital works. ROA uses all assets; ROE only the shareholders' share; ROCE uses operating profit, before interest and tax, over the long-term capital employed, so it compares businesses with different debt levels on one footing. Average balances over the year are preferred; the example below uses year-end balances for simplicity.

Liquidity ratios and their formulas

Current ratio = Current assets / Current liabilities

Quick ratio = (Cash + Short-term investments + Receivables) / Current liabilities

Cash ratio = Cash and equivalents / Current liabilities

The SEC's Beginners' Guide to Financial Statements defines current assets as "things a company expects to convert to cash within one year" and current liabilities as "obligations a company expects to pay off within the year." The current ratio compares the two. Current assets minus current liabilities is the same comparison in dollars: working capital.

The quick ratio, or acid-test ratio, leaves out inventory and prepaid items, because inventory has to be sold, and then collected, before it is cash. The cash ratio leaves out receivables too, so it is the strictest test.

Worked example: two years of one distributor

One distributor, fiscal years 2024 and 2025, in USD millions, with tax at 25% and year-end balances.

Net income is (operating profit − interest) × 0.75: (5.3 − 0.6) × 0.75 = 3.525 and (4.9 − 0.7) × 0.75 = 3.150. Capital employed is total assets minus current liabilities: 28.0 and 29.5.

In Excel, with the lines above in rows 2 to 15 (revenue in row 2) and FY25 in column C, each ratio is one division: =C4/C2 for gross margin, =C8/C13 for ROA, =C6/(C13-C14) for ROCE and =(C9+C10)/C14 for the quick ratio.

Reading the movement

Revenue grew 9.7%, but gross margin slipped a point and operating expenses grew faster than gross profit, so operating profit fell from $5.3 million to $4.9 million and every return fell with it. At the same time, receivables grew 15.8% and inventory 20.0%, both faster than sales, funded by cash and by more current liabilities, so the quick ratio dropped below 1.0.

In three sentences: the company bought growth with price or mix and with working capital. It earns less on each dollar of sales and ties up more cash to make it. The next questions are which customers are paying more slowly and which sites are holding more stock; credit limit headroom covers the first.

The check that proves it

The DuPont identity splits ROE into three ratios that must multiply back to it:

ROA = Net margin × Asset turnover

ROE = Net margin × Asset turnover × Equity multiplier

where asset turnover is revenue / total assets and the equity multiplier is total assets / equity. On FY25:

Both products equal the direct calculations in the table above. On FY24 the same check gives 5.69% × 1.550 = 8.8% and 8.8% × 2.222 = 19.6%. The CFA reading describes DuPont analysis as breaking ROE "into components that are indicators of different aspects of company performance": here asset turnover barely moved (1.550 to 1.545) and leverage rose slightly (2.222 to 2.256), so the whole fall in ROE comes from the net margin.

Where it goes wrong

• Year-end against average balances. In a growing company, ROA on year-end assets understates the return: FY25 ROA is 7.2% on year-end assets and 7.5% on the average of 40.0 and 44.0. Pick one and use it every year.
• A current ratio above 1 read as safe. If most current assets are slow inventory, check the quick ratio. Here the current ratio of 1.57 looks comfortable; the quick ratio of 0.91 does not.
• Unlike accounting. Leases on the balance sheet, capitalized development costs or a different inventory method move assets and profit, so ratios across companies are not on the same base.
• One year read alone. A ratio's trend, and its peers, matter more than its level.
• ROE inflated by debt. A high ROE with a high equity multiplier is leverage, not operating performance. ROCE strips it out.

Ratios from your own ledger

A falling quick ratio says receivables and inventory grew; the ledger says which customers and which sites. Covirage's tools compute the ratios from the ledger exports finance teams already have and open each movement to the rows behind it; the external AI model explains the movement and never does the arithmetic. See Covirage for finance teams. For the wider set finance teams report, see financial KPIs; for single ratios in depth, return on assets and cash conversion cycle.