By David R. Natan, CPA, MST, CVA | October 8, 2025
When you’re considering buying a business, the financials play a pivotal role in helping you determine whether the investment is worthwhile. Understanding key financial ratios will not only help you assess the potential of the business but also enable you to identify any underlying financial issues that might affect your decision.
In this blog, we’ll explore the most important financial ratios that every entrepreneur should understand before making a business purchase. By reviewing these ratios, you’ll be able to make a more informed decision about the financial health and viability of the business you’re interested in.
1. Liquidity Ratios: Assessing Short-Term Financial Health
Liquidity ratios measure a business’s ability to meet its short-term obligations. When you’re looking at a potential acquisition, it’s critical to assess whether the business can pay its bills and manage daily operations without financial strain.
Current Ratio
The current ratio compares a company’s current assets (cash, receivables, inventory) to its current liabilities (accounts payable, short-term debt). A ratio of 1 or higher suggests that the business has sufficient assets to cover its short-term liabilities. However, a ratio that’s too high could indicate that assets aren’t being used efficiently.
Formula: Current Ratio = Current Assets / Current Liabilities
Quick Ratio
The quick ratio, or acid-test ratio, is a more stringent measure of liquidity because it excludes inventory from the assets. This gives a clearer view of whether the business can meet its obligations with its most liquid assets. A ratio of 1 or higher indicates a strong ability to cover short-term debts without relying on inventory sales.
Formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
2. Profitability Ratios: Evaluating Operational Efficiency
Profitability ratios are critical for determining whether the business can generate enough income to cover expenses and provide a return on investment. These ratios help you evaluate how well the business uses its assets to produce profits.
Gross Profit Margin
The gross profit margin indicates the percentage of revenue that exceeds the cost of goods sold (COGS). A higher gross profit margin means the business can cover its operating expenses more easily and has more room for profit.
Formula: Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
Net Profit Margin
The net profit margin measures how much profit a company generates from its total revenue, factoring in all expenses (operating costs, taxes, interest, etc.). A higher net profit margin suggests that the business is efficiently managing its costs relative to its revenue.
Formula: Net Profit Margin = Net Income / Revenue
Return on Assets (ROA)
Return on assets indicates how efficiently a company is using its assets to generate profit. A higher ROA shows that the company is effective in utilizing its assets to generate earnings.
Formula: ROA = Net Income / Total Assets
3. Leverage Ratios: Understanding Debt Levels
Leverage ratios help assess how much debt a company is using to finance its operations. High debt levels can increase financial risk, especially if the business’s cash flow can’t support debt repayment. These ratios are essential to determine the potential risks involved in the acquisition.
Debt-to-Equity Ratio
This ratio compares a business’s total debt to its equity (owner’s investment in the business). A high debt-to-equity ratio can indicate that the business is highly leveraged, which may be risky in case of economic downturns or low cash flow.
Formula: Debt-to-Equity Ratio = Total Debt / Shareholder’s Equity
Debt-to-Asset Ratio
The debt-to-asset ratio shows the proportion of a company’s assets that are financed by debt. A lower ratio is generally preferable, as it indicates the business relies less on debt to finance its assets.
Formula: Debt-to-Asset Ratio = Total Debt / Total Assets
4. Efficiency Ratios: Analyzing Operational Effectiveness
Efficiency ratios provide insights into how well a business is managing its resources and operations. These ratios help you understand whether the business is using its assets effectively to generate revenue.
Inventory Turnover Ratio
This ratio measures how many times a company’s inventory is sold and replaced over a period. A high inventory turnover indicates that the business is selling its products quickly, while a low turnover may indicate overstocking or weak sales.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Accounts Receivable Turnover
This ratio assesses how effectively a company is collecting payments from customers. A high accounts receivable turnover ratio indicates that the business collects its outstanding receivables quickly, improving cash flow.
Formula: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
5. Valuation Ratios: Determining the Business’s Market Value
Valuation ratios help you evaluate whether the business is priced fairly in relation to its earnings, revenue, or assets. These ratios are critical when deciding if the asking price is reasonable for the business’s financial standing.
Price-to-Earnings (P/E) Ratio
The P/E ratio compares the company’s current share price to its per-share earnings. A high P/E ratio may indicate that the business is overvalued, while a low P/E ratio could signal that it’s undervalued. However, P/E ratios vary by industry, so it’s important to compare with industry peers.
Formula: P/E Ratio = Market Price per Share / Earnings per Share
Price-to-Sales (P/S) Ratio
The P/S ratio compares the business’s market capitalization to its total sales or revenue. This ratio is useful for companies that may not be profitable yet but still generate substantial revenue. A low P/S ratio may indicate that the business is undervalued.
Formula: P/S Ratio = Market Price per Share / Revenue per Share
6. Cash Flow Ratios: Measuring Cash Generation and Usage
Cash flow is the lifeblood of any business. Cash flow ratios help you understand how effectively a business generates cash to meet its obligations and invest in future growth.
Operating Cash Flow Ratio
This ratio compares a company’s operating cash flow to its current liabilities. A ratio greater than 1 indicates that the company generates enough cash to cover its short-term obligations, which is a positive sign of liquidity.
Formula: Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Free Cash Flow (FCF)
Free cash flow is the cash that a business generates after accounting for capital expenditures. Positive free cash flow indicates that the business has money available to reinvest, pay dividends, or reduce debt.
Formula: Free Cash Flow = Operating Cash Flow – Capital Expenditures
Conclusion
Understanding these key financial ratios will provide you with a comprehensive picture of a potential business’s financial health and risks. They will help you identify strengths and weaknesses, evaluate operational efficiency, assess debt levels, and ultimately determine whether the business is a solid investment.
Before you buy a business, make sure to conduct a thorough financial analysis using these ratios. Working with a financial advisor or accountant to interpret these ratios and ensure you’re making an informed decision is always a smart approach.
At Newburg CPA, we specialize in helping entrepreneurs evaluate businesses before they buy. Contact us today to learn more about how we can assist with your business acquisition process.