Making Sense of Financial Ratios: The Metrics that Matter
If there were a handful of financial ratios that told you how the organization was performing and how well it’s positioned for the future, would you want to know what they are?
The concept of financial management can seem overly complicated with hundreds of different ratios that can be evaluated and tracked. Ratios can focus on people and culture, project level production, company liquidity, brand, billings, overhead effectiveness — literally every aspect of the business has its own key ratios and measurements. The challenge is that each ratio is focused on a different metric and tells a piece of the overall story.
When you take a step back and reflect on the purpose of a ratio, it simplifies information by distilling it into a consumable size, creating comparisons over time and between firms. Ratios are the first step in asking the right questions. If you see a change in a cash ratio, it flags the need to dig deeper. If turnover is edging higher, we need to investigate what people are saying in exit interviews and look into what parts of the firm are the most impacted, average tenure of those leaving, team they were on and other issues.
Ratios serve as early warning signs. Depending on what that ratio evaluates and the frequency it is calculated, a story develops. Some ratios have industry standards; others are trends.
A handful of company ratios stand out as the starting point for understanding the health of the company. The ratios focus on liquidity, leverage and profitability. Together they measure how effectively the company can cover financial obligations, debt risk and company performance.
Looking at Key Ratios
We will explore three categories of financial ratios: liquidity, leverage and performance.
Liquidity Ratios
Liquidity is a measure of the company’s ability to maintain adequate cash to meet obligations as they become due. Liquidity makes the company stronger and shelters it in changing economic conditions. There is a balance between having too little liquidity and running the risk of financial failure and having too much and not generating sufficient return. The former being the most common risk industry firms face.
Two ratios are commonly used to evaluate liquidity: current ratio and the quick or acid test ratio.
Current assets are cash and anything that turns to cash over the course of one year in normal business operations. Current liabilities are anything that will consume cash in that same period of time. Knowing the balance between what turns to cash and what consumes it is one of the most critical financial relationships. Both ratios identify how well the company’s liquidity is structured for the coming year.
The current ratio is calculated by dividing current assets by current liabilities. A sample calculation looks like:
- Current Ratio = Current assets/Current liabilities
- Current Ratio = $4,092,929/$2,714,791
- Current Ratio = 1.51 to 1
In other words, for every $1 of current liabilities the company has $1.51 to cover them. A deeper explanation can be found in FMI’s book “Profitable Project | Profitable Business” along with target ranges for different types of contractors. For most contractors, a current ratio of 1.5 to 1 is good.
The quick ratio uses only cash and accounts receivable and divides it by the all current liabilities. The result is a smaller number than $1.51 and considers timing. Should all current liabilities come due tomorrow, cash and accounts receivables are what is readily available to pay for them. The need for covering all current liabilities in the near term is an unlikely situation, but reflects an “acid” test of liquidity.
Leverage
Leverage ratios are designed to measure the company’s vulnerability to business downturns. Generally, the more equity, the lower the risk profile of the company and the better its staying power. While there are numerous leverage ratios, we will focus on debt to equity.
Debt to equity measures the relationship between capital provided by creditors to that provided by shareholders. The ratio is calculated as follows.
- Debt to Equity = Total liabilities/Total equity
- Debt to Equity = $3,235,328/$2,046,171
- Debt to Equity = 1.58 to 1
In the sample above, for every $1 the shareholders have in the business, creditors have $1.58. Or said another way, creditors have 61% of the assets and shareholders have 49%.
Having some debt allows the company to operate and generate a return over and above what shareholders can finance with equity alone. Too much or too little debt is not a good thing. Too little and profit generation is challenged, too much and you may not be able to get bank capacity when it is needed the most.
Profitability Ratios
Profitability ratios measure net earnings, usually before taxes, against a base amount. The most common comparisons are earnings as a percentage of revenue and earnings as a percentage of equity. The construction industry has a relatively low level of earnings on revenue as a percent. For top performing companies that return might be 2% - 5%,whereas return on equity might range from 25% – 40%. The difference is the result of leverage in the business.
Together liquidity, leverage and performance ratios provide a high-level overview of the health of the business.
Financial ratios are more than just figures on a page — they are the lens through which a company’s story is told. They reveal how well the business manages its resources, balances risk and generates value. When interpreted thoughtfully, these ratios serve as early indicators of opportunity or warning, guiding leaders toward smarter decisions. In the end, knowing your key ratios, and understanding what drives them, isn’t simply about numbers; it’s about gaining the clarity needed to build a stronger, more resilient and more profitable organization.
