How To Calculate Ratios (With Example)

By Indeed Editorial Team

March 15, 2021

Businesses use many methods for analyzing financial data to determine whether they are meeting their goals. One of the most common calculations that business analysts and other finance professionals use is a ratio, which shows how two numbers relate to each other. In this article, we explain how you can use ratios in business and how to calculate them.

Business uses for ratios

Businesses use ratios to calculate their financial success, allocate resources and determine if they are meeting their goals. Ratios allow businesses to compare data over time and understand how different types of information relate to each other. Here are some ways that businesses use ratios:

Profitability
Cash flow and liquidity
Financial risk and return
Stock turnover and sales
Key performance indicators (KPIs)
Employee tracking
Product returns

Profitability

Profitability is a ratio that accountants and analysts use to determine how well a business is doing. A profitability ratio can be based on the gross profit margin, which is the difference between the sales price of a product and the cost of making the product. They can also use net profit margin, which is the difference between gross profit and overhead costs. They would find the profitability ratio by determining what percentage of the overall revenue is profit.

Cash flow and liquidity

Businesses usually want to know how much capital and liquid assets they have. Working capital ratio, or current ratio, is how much capital a business has to pay its debts. It shows how a business's overall assets relate to its liabilities, and it is often used to measure a company's financial strength. A quick assets ratio shows how much money a company has readily available or can be easily converted to cash compared to its liabilities. Both are used to determine the value of a company and whether it can meet its financial obligations.

Financial risk and return

Financial risk and return ratios tell a business owner or analyst how healthy the company's investments are. Understanding these ratios can help them determine how successful their current investments are and how future investments will affect the business.

Return on investment (ROI) ratios explain how much money was made in relation to how much money was invested in the company. To find an ROI ratio, compare net profit before taxes to your total assets. You can determine the risk of an investment by comparing its ROI to a different, risk-free investment. If the ROI of the riskier investment is lower than the risk-free one, you may want to consider other investment choices.

Stock turnover and sales

These ratios help businesses measure how quickly they are selling products. They are able to determine where they have excess stock and if they need to change production processes. A stock turnover ratio measures how often a business sells and replaces its goods. Usually, the higher this number is, the higher the ROI. A material to sales ratio measures how a company's cost of direct materials, like raw materials or wholesale products, compares to its total sales. The higher the material to sales ratio, the higher the ROI and profits will be.

Key performance indicators (KPIs)

Managers can use ratios to determine how well their staff meets KPI expectations. These ratios can help managers understand where employees may need more coaching, where they are excelling and if the business is meeting performance goals. You can compare the actual KPI scores to the goal to determine the ratio of how an individual employee or an entire department is doing.

Employee tracking

Ratios can be used to determine how individual employees are performing, and how labor costs can affect profits. Organizations can compare labor costs to total revenue to determine whether they should increase or decrease labor costs. They can also use the staff turnover ratio to help determine employee satisfaction. People are more likely to work in places where they feel they are appreciated, well-compensated and supported. They would find the staff turnover ratio by comparing the number of employees who left to the total number of staff.

Product returns

You can use ratios to determine the rate that products are being returned. This ratio can give you insight into products that are faulty or don't meet customer expectations. It can also help determine patterns of returns and what items need to be redesigned or discontinued. To find the product return ratio, compare the number of items that were returned over a period of time to the total sales over that same time.

How to calculate a ratio

Here are the steps to calculating a ratio:

Determine the purpose of the ratio. You should start by identifying what you want your ratio to show. Each ratio will use different data, and you want to be sure you are using the correct information to give you the details you are looking for.
Set up your formula. Ratios compare two numbers, usually by dividing them. If you are comparing one data point (A) to another data point (B), your formula would be A/B. This means you are dividing information A by information B. For example, if A is five and B is 10, your ratio will be 5/10.
Solve the equation. Divide data A by data B to find your ratio. In the example above, 5/10 = 0.5.
Multiply by 100 if you want a percentage. If you want your ratio as a percentage, multiply the answer by 100. To continue the example, 0.5 x 100 = 50%.

Ratio example

Here's an example of using a ratio in the workplace:

You want to find out the ratio of employees who are not meeting their KPIs. There are 200 employees and five aren't meeting the KPIs.

Determine the purpose of the ratio. To find the ratio of employees, you need to measure the number of employees who did not meet their sales goal (5) compared to the total number of employees (200).
Set up the formula. To set up the equation, put the basis of the comparison on the bottom. In this case, your equation will look like (people who did not meet their goals) / (total number of employees), or 5/200.
Solve the equation. 5/200 = 0.025. You can choose to leave your ratio like this. There are some cases where you won't need to make it a percentage, though many people prefer to make it a percentage so it's easier to read.
Multiply by 100. To make 0.025 a percentage, you would multiply it by 100. 0.025 x 100 = 2.5. This means that 2.5% of employees are not meeting their weekly sales goals.