Ratio analysis is a method of evaluating a business by dividing one figure in its financial statements by another to produce a ratio that can be compared over time, against competitors or against a lender's requirements. Turning raw amounts into ratios removes the effect of company size, so a small firm and a large one can be judged on the same scale.
It is used by investors choosing shares, by banks setting loan terms and covenants, by suppliers deciding how much credit to give, and by managers tracking their own performance. Ratio analysis sits alongside horizontal analysis, which compares figures across years, and vertical analysis, which shows each line as a percentage of a total such as sales.
Main groups of ratios
| Group | What it shows | Common examples |
|---|---|---|
| Liquidity | Ability to pay obligations due within a year | Current ratio, quick ratio |
| Solvency or leverage | Reliance on debt and ability to service it | Debt-to-equity, interest coverage |
| Efficiency or activity | How well assets are used | Inventory turnover, receivables turnover, asset turnover |
| Profitability | How much profit is earned on sales and capital | Gross margin, net profit margin, return on equity |
| Market value | How the market prices the shares | Price-to-earnings, dividend yield |
Typical liquidity measures include the current ratio and the stricter quick ratio. Solvency is often judged with the debt-to-equity ratio and the interest coverage ratio. Efficiency ratios include the inventory turnover ratio and the asset turnover ratio. Profitability ratios include profit margin and return on equity, and market ratios include the price-to-earnings ratio.
Worked example
A furniture retailer reports sales of $5,000,000, net income of $300,000, current assets of $1,400,000 including inventory of $800,000, current liabilities of $700,000, total debt of $1,200,000 and shareholders' equity of $2,000,000. Some key ratios are:
- Current ratio: $1,400,000 divided by $700,000 gives 2.0.
- Quick ratio: $600,000 of non-inventory current assets divided by $700,000 gives about 0.86.
- Net profit margin: $300,000 divided by $5,000,000 gives 6 percent.
- Debt-to-equity: $1,200,000 divided by $2,000,000 gives 0.6.
- Return on equity: $300,000 divided by $2,000,000 gives 15 percent.
Read together, these suggest a profitable, moderately geared business whose short-term liquidity depends on selling its stock. One way to connect profitability ratios is the DuPont breakdown:
Here the first term is net profit margin, the second is asset turnover and the third is the equity multiplier, a measure of leverage. If the retailer has total assets of $3,200,000, its asset turnover is about 1.56 and its equity multiplier is 1.6, so 6 percent times 1.56 times 1.6 gives the same 15 percent return on equity.
Limitations of ratio analysis
Ratios are only as reliable as the numbers behind them. Different accounting choices, such as FIFO or LIFO inventory or different depreciation methods, can make similar companies look different. Balance sheet figures are a single day's snapshot and may be affected by seasonal swings or year-end timing. Inflation distorts comparisons between old assets at historical cost and current sales. A ratio on its own says little: it needs a benchmark, such as the company's past results, an industry average or a loan covenant. Ratios also point to questions rather than answers. A falling margin shows that something has changed but not why, so analysts follow up by reading the notes, management commentary and the cash flow statement.