Financial ratios: What do they mean? (Part 3)

A1Ratio analysis can be used when financial information needs to be simplified to make it possible to interpret and compare the information. Banks often do ratio analysis when they need to decide whether to lend money to a client or not. If a business wants to open an account with a supplier, the suppliers often use ratio analysis to determine the financial health of the business before deciding if they will sell to the business on credit.

In Part 1 and Part 2 of this series of articles on financial ratios, the limitations of using ratios have been mentioned. However, there are also certain advantages to making use of ratio analysis. Some of these advantages are:

  • Ratios simplify the relationships between different amounts in a way that is easy to understand.
  • Ratio analysis allows the user to get a bird’s-eye view of the changes that have taken place in the financial condition of a business.
  • Ratio analysis makes it easier to compare different businesses with each other.
  • Comparisons can be made in the same business, between different years or divisions, to monitor the efficiency and performance of business units.
  • Ratio analysis can be used in planning by using past ratios to forecast future financial situations e.g. when drawing up a budget. 

Financial risk ratios

Financial risk ratios, also known as solvency ratios, are used to determine the long term financial health of a business by determining whether the business carries too much or too little debt.

  • Debt ratio (also known as gearing):

Formula: Liabilities/Assets

A business can finance its assets with capital from the owner(s) or money borrowed from a bank or similar institution. The debt ratio determines the proportion of the assets of a business that are financed through debt, e.g. a debt ratio of more than 0.5 means more than half of the business’s assets are financed through debt. A debt ratio of less than 0.5 means most of the business’s assets are financed through capital (equity).

  • Equity ratio:

Formula: Equity/Assets

The equity ratio is a variant of the debt ratio above. The equity ratio shows the proportion of the assets of a business that are financed through equity.

  • Times interest earned (Interest cover):

Formula: Profits before interest paid and income tax / Interest paid

This ratio indicates whether a business will be able to make the interest payments on its debts from its profits. For example, a ratio of 2.5:1 means that the business earns two and a half times the amount that is needed to cover its interest expense.

  • Free cash flow ratio:

Formula: Cash flow from operating activities – Capital expenditure

The free cash flow ratio gives the amount of cash from operations that is left after a business paid for its capital expenditure. This is the amount of cash that is available to repay loans to banks and loans from the owner(s) to the business, and to make investments.

  • Cash flow coverage ratio:

Formula: Operating cash flows / Total debt

Banks often look at this ratio when they have to decide if they will make a loan to a business as this ratio tells if a business will be able to make capital and interest payments on loans when they become due.

A ratio of 1:1 means the business is in a good liquidity position or in good financial health. A ratio of less than 1 implies that the business does not earn enough profits to be able to pay capital and interest out of its earnings. If a business has a ratio of less than 1, there is a good chance of bankruptcy within the next few years if the business does not do something to improve its financial position.

The above ratios are used to give an indication of the financial health of a business. It is important to remember that different industries have different norms and what is interpreted as a problematic ratio in one industry, can be perfectly acceptable in another industry.

For professional assistance and advice on this topic, please contact our offices.

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. 

Reference List:




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IC Marais

Professional experience:

IC Marais is a certified CA (SA) with public sector and private sector technical knowledge based on 5 years’ Public Sector accounting, auditing and financial management experience and 5 years audit, tax and accounting experience. Detailed knowledge of private and public sector accounting and auditing standards (GRAP, IPSAS, IFRS, IAS, ISA) and public sector financial legislation (MFMA, etc.)

He enjoys the outdoors, hunting and fishing.


Professional experience:

In 1995, Schalk started as a trainee at Warner and Newton (which became Moores Rowland in 1997 and then Mazars Moores Rowland in 2007) in Bloemfontein. In 1998, Schalk was appointed as manager at Moores Rowland, where he became a partner in 2003. Schalk received his Postgraduate Certificate in Advanced Taxation in 2006 and in 2009 he received his Certificate in the Administration of Estates.


Professional experience:

Cedric started as a trainee at Warner and Newton (which became Moores Rowland in 1997 and Mazars Moores Rowland in 2007), Bloemfontein, in 1986. After completion of his articles, he joined the Special Investigations Division of the Department of Finance (SA Revenue Services) as a senior inspector from 1990 to 1991.


Professional experience:

Lucha started her career as a tax inspector at the Inland Revenue Department of New Zealand. After this she worked in commerce in Canada, Mexico and the United States.

On her return to South Africa, she completed her CA training contract with us and has been with Newtons ever since. She became a Partner in 2012.

Apart from her CA(SA) qualification she also holds a postgraduate certificate in Advanced Taxation (2005) and has the overall responsibility for training as our Training Officer.