Ratio Analysis: A Practical Guide
What is ratio analysis?
Ratio analysis uses figures from a company’s financial statements to evaluate its liquidity, efficiency, profitability, and solvency. Rather than a single metric, it is a toolkit of relationships (ratios) that help investors, managers, and creditors assess performance, compare firms, and track trends over time.
Why it matters
- Converts raw financial data into interpretable measures.
- Helps identify strengths, weaknesses, and trends that raw totals may hide.
- Supports comparisons across time, among peers, and against internal or external benchmarks.
- Commonly used in lending decisions, valuation, and operational reviews.
How ratio analysis works
- Ratios are calculated from items on the balance sheet, income statement, cash-flow statement, and equity statement.
- They are most useful when compared to:
- Historical values for the same company (trend analysis).
- Industry peers or sector averages (comparative analysis).
- Predefined targets or covenant thresholds (benchmarking).
- Use multiple ratios together; no single ratio gives a complete picture.
Key limitations
- Can be distorted by accounting policies, seasonality, one‑time events, or short-term actions that change ratios without changing fundamentals.
- Industry differences make absolute comparisons misleading—interpret ratios in context.
- Ratios are descriptive, not predictive; they require qualitative and forward-looking analysis to infer future performance.
- Vulnerable to manipulation through timing, classification, or accounting choices.
Main types of ratios (with examples)
- Liquidity ratios — ability to meet near‑term obligations
- Current ratio = Current assets / Current liabilities
- Quick ratio (acid-test) = (Current assets − Inventory) / Current liabilities
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Working capital = Current assets − Current liabilities
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Solvency (leverage) ratios — long-term capital structure and debt risk
- Debt-to-equity = Total debt / Shareholders’ equity
- Debt-to-assets = Total debt / Total assets
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Interest coverage = EBIT / Interest expense
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Profitability ratios — ability to produce earnings
- Net profit margin = Net income / Revenue
- Gross margin = Gross profit / Revenue
- Return on assets (ROA) = Net income / Total assets
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Return on equity (ROE) = Net income / Shareholders’ equity
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Efficiency (activity) ratios — how well assets are used to generate sales
- Asset turnover = Revenue / Total assets
- Inventory turnover = Cost of goods sold / Average inventory
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Days sales outstanding (DSO) = Receivables / Average daily sales
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Coverage ratios — capacity to service debt and fixed obligations
- Times interest earned = EBIT / Interest expense
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Debt-service coverage ratio = Operating cash flow / Debt service
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Market (valuation) ratios — investor-oriented measures of value and return
- Price-to-earnings (P/E) = Market price per share / Earnings per share
- Earnings per share (EPS)
- Dividend yield = Annual dividends per share / Market price per share
- Dividend payout ratio = Dividends / Net income
How to apply ratio analysis
- Over time (trend analysis): calculate a ratio at regular intervals to detect direction, rate of change, and seasonality effects.
- Tip: adjust for seasonality and cyclical business effects before drawing conclusions.
- Across peers (comparative analysis): compare with companies in the same industry and of similar size/capital structure.
- Ensure comparisons use consistent accounting conventions and consider business model differences.
- Against benchmarks: use internal targets or external covenants (e.g., lender-required coverage ratios) to monitor compliance and strategy.
Practical examples
- Profit margin comparison: Company A has a net margin of 50% and Company B 10%. All else equal, A converts far more revenue into profit. If A’s P/E is 100 and B’s is 10, investors are assigning much higher future growth or quality to A.
- Inventory turnover: Tracking monthly inventory turnover reveals whether inventory management is improving or deteriorating and helps diagnose slow-moving stock or supply‑chain issues.
Best practices
- Use a battery of ratios from different categories rather than relying on one metric.
- Understand the drivers behind a ratio—changes in revenue, margins, asset levels, or accounting policy can all affect results.
- Normalize for one‑time items and nonrecurring events when comparing periods.
- Interpret ratios in the context of industry norms, company lifecycle stage, and economic conditions.
- Pair quantitative ratio analysis with qualitative assessment (management, strategy, market position).
Conclusion
Ratio analysis distills financial statements into actionable measures that clarify a company’s financial condition and performance trends. When used thoughtfully—combined across ratio types, adjusted for context, and supplemented with qualitative judgement—it is a powerful tool for investors, managers, and creditors.