RATIO ANALYSIS

Definition

Ratio Analysis is a quantitative method of evaluating the financial performance, health, and efficiency of a business by examining the relationships between line items in its financial statements. Ratios provide insights into liquidity, profitability, solvency, efficiency, and valuation, making them essential tools for investors, creditors, analysts, and managers.

Origins

In accounting and finance, the systematic use of ratios began to emerge in the early 20th century, gaining wider adoption as analysts sought to assess corporate performance and risk more effectively.

Usage

Ratio analysis is widely used in:

• Investment analysis (e.g., stock screening, portfolio construction).

• Credit evaluation (e.g., loan approvals, bond ratings).

• Internal performance reviews (e.g., benchmarking, KPIs).

• M&A due diligence (to assess the target's financial health and identify potential synergies).

• Financial forecasting and modeling.

How Ratio Analysis Works

Ratio analysis involves calculating and interpreting ratios by dividing one financial metric by another to identify trends, strengths, and weaknesses.

Five Main Categories of Ratios:

• Liquidity Ratios – Can the firm meet short-term obligations?

• Profitability Ratios – Is the firm generating profit efficiently?

• Solvency (Leverage) Ratios – Can the firm meet long-term obligations?

• Efficiency (Activity) Ratios – How effectively are assets managed?

• Valuation Ratios – How is the market pricing the company?

Key Takeaway

• Ratio analysis translates raw financial data into actionable insights.

• It enables comparative analysis across time periods and peer companies.

• It identifies operational weaknesses, credit risks, and valuation gaps.

• Ratios vary by industry and company size; context is critical.

Types of Financial Ratios

1. Liquidity Ratios

Measure the ability to meet short-term obligations.

• Current Ratio: 

  $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

• Quick Ratio (Acid-Test):

  $$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$$

• Cash Ratio:

  $$\text{Cash Ratio} = \frac{\text{Cash + Cash Equivalents}}{\text{Current Liabilities}}$$
  

2. Profitability Ratios 

Assess the firm’s ability to generate earnings.

• Gross Margin:

  $$\text{Gross Margin} = \frac{\text{Revenue} - \text{COGS}}{\text{Revenue}} \times 100$$

• Operating Margin:

  $$\text{Operating Margin} = \frac{\text{Operating Income}}{\text{Revenue}} \times 100$$

• Net Profit Margin:

  $$\text{Net Margin}=\frac{\text{Net Income}}{\text{Revenue}}\times \mathrm{100<br><br><br>}$$

• Return on Assets (ROA):

  $$\text{ROA}=\frac{\text{Net Income}}{\text{Total Assets}}\times \mathrm{100<br><br><br>}$$

• Return on Equity (ROE):

  $$\text{ROE}=\frac{\text{Net Income}}{\text{Shareholders’ Equity}}\times 100$$

3. Solvency (Leverage) Ratios

Measure long-term financial stability and debt levels.

• Interest Coverage Ratio:

  $$\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}}$$

• Debt-to-Equity Ratio:

  $$\text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Total Equity}}$$

• Debt Ratio:
  

  $$\text{Debt Ratio}=\frac{\text{Total Liabilities}}{\text{Total Assets<br><br><br>}}$$$$\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$$

4. Efficiency (Activity) Ratios

Evaluate how effectively a firm uses its resources.

• Inventory Turnover:

  $$\text{Inventory Turnover} = \frac{\text{COGS}}{\text{Average Inventory}}$$

• Receivables Turnover:

  $$\text{Receivables Turnover}=\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable<br><br>}}$$

• Asset Turnover:

  $$\text{Asset Turnover}=\frac{\text{Net Sales}}{\text{Average Total Assets<br><br>}}$$

• Days Sales Outstanding (DSO):

  $$\text{DSO} = \left( \frac{\text{Accounts Receivable}}{\text{Net Sales}} \right) \times 365$$

5. Valuation Ratios

Used by investors to assess company value relative to price.

• Price-to-Earnings Ratio (P/E):

  $$\text{P/E Ratio} = \frac{\text{Share Price}}{\text{Earnings Per Share (EPS)}}$$

• Price-to-Book Ratio (P/B):

  $$\text{P/B Ratio} = \frac{\text{Market Price Per Share}}{\text{Book Value Per Share}}$$

• EV/EBITDA:

  $$\text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}}$$

• Dividend Yield:

  $$\text{Dividend Yield} = \frac{\text{Dividend Per Share}}{\text{Price Per Share}} \times 100$$
  
  

Context in Financial Modeling

Ratio analysis is central to:

• DCF and Comparable Company Analysis

• Credit risk modeling

• Sensitivity analysis (e.g., how changes in margins affect ROE)

• Scenario planning and covenant testing

• Investor presentations and pitch decks

Nuances & Complexities

• Seasonality: Ratios can vary significantly by quarter.

• Accounting Methods: Differences in depreciation or revenue recognition affect comparability.

• Industry Benchmarks: A “good” ratio in one industry may be poor in another.

• One-Off Items: Extraordinary gains/losses can distort ratios.

Related Terms

• Common Sizing

• Trend Analysis

• Financial Ratios

• DuPont Analysis

• KPI (Key Performance Indicators)

Real-World Applications

Example 1: Equity Research

Analysts use profitability and valuation ratios to recommend buy/sell/hold ratings.

Example 2: Lending Decisions

Banks assess liquidity and leverage ratios before approving loans.

Example 3: Corporate Strategy

Executives use ratio trends to identify cost-saving opportunities or expansion readiness.

References & Sources

• Investopedia: Financial Ratio Analysis