Financial ratio analysis reduces a company’s financial statements to comparable numbers (ratios) that can be compared across years or against industry norms. A single dollar amount doesn’t say much. $50M in inventory is a lot for a small retailer, almost nothing for Walmart. A ratio normalises away scale.
Ratios fall into four groups, mirroring the four financial objectives of Financial management and Assessing financial strength:
Liquidity ratios — ability to meet short-term obligations
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Working capital = Current Assets − Current Liabilities. A dollar amount, not really a ratio. Should be positive; negative working capital means short-term obligations exceed short-term resources.
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Current ratio = Current Assets / Current Liabilities. The relative version of working capital. Rule of thumb: aim for ≥ 2, certainly above 1.
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Acid-test ratio (quick ratio) = Quick Assets / Current Liabilities, where quick assets exclude inventories, only the assets that can become cash immediately. Rule of thumb: aim for ≥ 1.
Profitability ratios — ability to generate profit
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Profit margin = Net Income / Sales. How much of each sales dollar ends up as profit. The headline profitability number.
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Return on Assets (ROA) = Net Income / Total Assets. How efficiently the company’s asset base produces income. (ROA straddles profitability and efficiency: it sits in this group because it measures dollars of profit per dollar of assets, but it’s also a standard efficiency metric since it captures asset productivity.)
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Return on Equity (ROE) = Net Income / Total Equity. The return owners earn on their stake. Often the most-watched number by investors.
ROE > ROA is normal (because the firm uses leverage). The gap measures financial leverage’s contribution to equity returns.
Efficiency ratios — ability to use assets productively
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Inventory turnover = Sales / Inventory (this course’s convention). How quickly inventory is sold and replaced. High turnover means inventory isn’t sitting around; low turnover suggests too much inventory relative to sales. Standard accounting uses COGS / Average Inventory instead: same idea but at cost basis rather than market price, and the form to use when comparing against published industry data.
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Asset turnover = Sales / Total Assets. How many dollars of sales each dollar of assets generates. Pairs naturally with profit margin: , the DuPont decomposition. A capital-intensive business (utility, steel mill) lives on low asset turnover with thick margins; a retailer lives on high asset turnover with thin margins.
Stability ratios — financial structure / leverage
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Debt ratio = Total Debt / Total Assets. What fraction of the asset base is financed by debt. Low = good (low risk); high = leveraged (more risk but potentially more return).
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Debt-to-equity = Total Debt / Owner’s Equity. Investors’ view: for each dollar of equity, how much debt is being carried. High D/E means stockholders will not be made whole in bankruptcy.
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Equity ratio = Total Equity / Total Assets. Mirror image of the debt ratio (Equity ratio + Debt ratio ≈ 1).
Ratio analysis comparison
Good signs:
- Rising profit margins year over year.
- Stable current and quick ratios (no liquidity squeeze).
- Decreasing debt ratios (less leverage over time).
Bad signs:
- Low pro forma ratios (the projections aren’t strong).
- Low return on assets (assets aren’t producing returns).
- Trends moving the wrong way.
Rules of thumb (general benchmarks):
- Current ratio ≈ 2.
- Acid-test ratio ≈ 1.
But specific values are themselves neither good nor bad; what matters is what they imply in context. A current ratio of 5 might mean liquid strength, or it might mean piles of unused cash that should be invested. A debt ratio of 0.8 is high for most businesses but normal for utilities and banks. Always compare against industry norms before drawing conclusions.
The numbers behind these ratios come off the Income statement, Balance sheet, and Statement of cash flows.