What ratio analysis is for
Raw financial statements are hard to compare. A company with $1 million of profit might be doing brilliantly or poorly depending on its size. Ratios convert statement figures into relationships that can be compared across years, firms and industries. They answer four basic questions: can the business pay its bills (liquidity), does it earn a return (profitability), does it use its assets well (efficiency) and how heavily is it financed by debt (leverage).
A single ratio means little. A ratio becomes meaningful when it is compared with something: the same company in earlier years, competitors, the industry average or a target. Always say what you are comparing against.
The main ratios and their formulas
| Group | Ratio | Formula | What it shows |
|---|---|---|---|
| Liquidity | Current ratio | Current assets divided by current liabilities | Ability to meet short-term obligations |
| Liquidity | Quick ratio | (Current assets minus inventory) divided by current liabilities | Liquidity without relying on selling stock |
| Profitability | Gross margin | Gross profit divided by revenue | Profit on products before overhead |
| Profitability | Operating margin | Operating income divided by revenue | Profit from core operations |
| Profitability | Net margin | Net income divided by revenue | Profit after all costs |
| Profitability | Return on assets (ROA) | Net income divided by total assets | Profit generated per dollar of assets |
| Profitability | Return on equity (ROE) | Net income divided by equity | Return to owners |
| Efficiency | Inventory turnover | Cost of goods sold divided by inventory | How quickly stock sells |
| Efficiency | Receivable days | Receivables divided by revenue, times 365 | How long customers take to pay |
| Efficiency | Asset turnover | Revenue divided by total assets | Sales generated per dollar of assets |
| Leverage | Debt ratio | Total liabilities divided by total assets | Share of assets financed by debt |
| Leverage | Debt-to-equity | Total liabilities divided by equity | Debt relative to owners' funds |
| Leverage | Interest coverage | Operating income divided by interest expense | Ability to pay interest from operations |
Textbooks vary on whether to use year-end or average balances for ratios such as ROA. Use whichever your course specifies. The examples below use year-end balances for simplicity.
A worked example: Northline Outfitters
Here are two years of summary figures for a hypothetical retailer, in thousands of dollars.
| Income statement | Year 1 | Year 2 |
|---|---|---|
| Revenue | 8,000 | 9,200 |
| Cost of goods sold | 5,200 | 6,210 |
| Gross profit | 2,800 | 2,990 |
| Operating expenses | 2,000 | 2,300 |
| Operating income | 800 | 690 |
| Interest expense | 100 | 150 |
| Tax at 25 percent | 175 | 135 |
| Net income | 525 | 405 |
| Balance sheet | Year 1 | Year 2 |
|---|---|---|
| Cash | 400 | 250 |
| Receivables | 700 | 1,000 |
| Inventory | 1,300 | 1,900 |
| Total current assets | 2,400 | 3,150 |
| Non-current assets, net | 3,000 | 3,400 |
| Total assets | 5,400 | 6,550 |
| Current liabilities | 1,200 | 1,800 |
| Long-term debt | 1,500 | 2,000 |
| Total liabilities | 2,700 | 3,800 |
| Equity | 2,700 | 2,750 |
The ratios, calculated
| Ratio | Year 1 | Year 2 | Direction |
|---|---|---|---|
| Current ratio | 2.00 | 1.75 | Weaker |
| Quick ratio | 0.92 | 0.69 | Weaker |
| Gross margin | 35.0 percent | 32.5 percent | Weaker |
| Operating margin | 10.0 percent | 7.5 percent | Weaker |
| Net margin | 6.6 percent | 4.4 percent | Weaker |
| ROA | 9.7 percent | 6.2 percent | Weaker |
| ROE | 19.4 percent | 14.7 percent | Weaker |
| Inventory turnover | 4.0 times | 3.3 times | Weaker (days of stock: 91 to 112) |
| Receivable days | 32 days | 40 days | Weaker |
| Asset turnover | 1.48 | 1.40 | Slightly weaker |
| Debt ratio | 50.0 percent | 58.0 percent | More leveraged |
| Debt-to-equity | 1.00 | 1.38 | More leveraged |
| Interest coverage | 8.0 times | 4.6 times | Weaker |
As a check on one of them: Year 2 current ratio is 3,150 divided by 1,800, which is 1.75. Year 2 net margin is 405 divided by 9,200, which is 4.4 percent. Show a formula and a worked line like this for each ratio in an assignment, then the table.
Interpreting the results
This is where the marks are. Do not repeat the numbers. Say what story they tell. For Northline:
Sales grew but profit fell. Revenue rose 15 percent, from 8,000 to 9,200, yet net income fell almost 23 percent, from 525 to 405. Growth was bought at a cost.
The cause is margin pressure. Gross margin dropped 2.5 percentage points, which suggests discounting or higher product costs, and operating expenses rose faster than sales, which pushed operating margin from 10.0 to 7.5 percent.
Working capital is absorbing cash. Inventory grew 46 percent and receivables 43 percent, far faster than revenue. Days of inventory rose from 91 to 112 and customers now take 40 days to pay instead of 32. Cash fell from 400 to 250.
Borrowing has increased risk. The debt ratio rose to 58 percent, and interest coverage nearly halved to 4.6 times, so a further profit fall would make debt servicing harder.
Liquidity has weakened. The current ratio of 1.75 is still comfortable, but the quick ratio of 0.69 shows the business depends on selling inventory to pay its bills.
Recommendations. Review pricing and discounting, tighten inventory purchasing, shorten credit terms or chase receivables, and slow the pace of borrowing until margins recover.
Notice the structure: finding, evidence, cause, consequence. That is the pattern to follow for each theme.
Working on this assignment now? Get a price for help with your paper.
Get an instant quoteDuPont analysis: why did ROE change?
The DuPont breakdown splits return on equity into three drivers: profitability, efficiency and leverage.
ROE = net margin x asset turnover x equity multiplier, where the equity multiplier is total assets divided by equity.
| Driver | Year 1 | Year 2 | Effect on ROE |
|---|---|---|---|
| Net margin | 6.56 percent | 4.40 percent | Large negative |
| Asset turnover | 1.48 | 1.40 | Small negative |
| Equity multiplier | 2.00 | 2.38 | Positive, but it raises risk |
| ROE (product) | 19.4 percent | 14.7 percent | Fell |
Year 1: 6.56 percent times 1.48 times 2.00 gives 19.4 percent. Year 2: 4.40 percent times 1.40 times 2.38 gives 14.7 percent. The breakdown shows that falling profitability is the main reason ROE dropped, and that extra borrowing only partly offset it, which makes the business riskier. It is a compact way to show insight.
A practice problem with solution
A company has revenue of 2,000, cost of goods sold of 1,200, operating income of 260, interest expense of 40 and net income of 160. It has current assets of 600 (of which inventory is 250), current liabilities of 400, total assets of 1,600, total liabilities of 800 and equity of 800. Calculate the main ratios and a DuPont check.
| Ratio | Working | Answer |
|---|---|---|
| Current ratio | 600 / 400 | 1.50 |
| Quick ratio | (600 - 250) / 400 | 0.88 |
| Gross margin | (2,000 - 1,200) / 2,000 | 40 percent |
| Operating margin | 260 / 2,000 | 13 percent |
| Net margin | 160 / 2,000 | 8 percent |
| ROA | 160 / 1,600 | 10 percent |
| ROE | 160 / 800 | 20 percent |
| Asset turnover | 2,000 / 1,600 | 1.25 |
| Debt ratio | 800 / 1,600 | 50 percent |
| Interest coverage | 260 / 40 | 6.5 times |
DuPont check: net margin 8 percent x asset turnover 1.25 x equity multiplier (1,600 / 800 = 2.0) = 20 percent, which matches ROE. Interpretation in one line: the company earns a solid 20 percent return for owners, with a healthy half of its assets financed by debt that is comfortably covered by operating profit.
Choose a fair benchmark
| Benchmark | Strength | Limit |
|---|---|---|
| Same company in earlier years (trend) | Shows direction and speed of change | Does not show whether the level is good |
| Competitors | Shows relative performance | Different accounting or business models can distort comparison |
| Industry average | Gives a standard for the sector | Averages hide a wide range of firms |
| Internal targets or covenants | Links to decisions | May not be public |
Use at least two benchmarks if you can, and say why they are appropriate. A ratio that looks weak against a competitor may be normal for a business with a different model.
Limits of ratio analysis
Show you understand what ratios cannot do. They rely on historical accounting data and can be affected by accounting policies, one-off items and seasonal timing. Year-end balances may not represent the year, for example a retailer's stock is often highest just after a peak season. Ratios show what happened, not why, and the causes need other evidence from the notes, the market and management. They also cannot capture things such as brand strength or staff quality. A brief comment on limits in your conclusion shows judgment.
- Show formulas and workings Give the formula once, then at least one worked calculation.
- Group the ratios Organize by liquidity, profitability, efficiency and leverage.
- Compare and explain Always say against what, and why it changed.
- Recommend End with actions supported by the analysis.
For help with a full ratio analysis report, you can order a financial ratio analysis.