Ratio analysis

Ratio analysis converts relationships within financial statements into comparable indicators of profitability, efficiency, liquidity and financing risk. It helps an analyst ask better questions about a business, but it does not by itself establish whether the business is healthy, fairly valued or able to meet every obligation.

When to use it

• Compare a company with carefully selected peers or relevant industry ranges.

• Examine how financial performance and risk have changed over time.

• Assess liquidity, debt-service capacity, operating efficiency and returns.

• Identify areas that require deeper review of statements, notes, cash flows and business context.

Origins

Financial-statement analysis developed alongside industrialisation and commercial lending in the United States during the latter half of the nineteenth century. Banks needed repeatable ways to judge whether business borrowers could repay. By the 1890s, lenders were comparing current assets with current liabilities—the relationship now called the current ratio. The practice expanded from simple lending rules into a broad family of analytical measures used by managers, creditors and investors.

What it is

Ratios standardise accounting relationships so that scale alone does not dominate comparison. Consider the results for three global smartphone firms:

The raw figures show that Firm A has the greatest sales, Firm B the greatest net income and Firm C relatively little inventory. Those observations do not reveal how effectively each firm converts resources into performance. Four broad categories help organise the analysis:

1. Profit sustainability: Can the firm produce adequate and durable returns? Measures include sales growth (current-period sales/previous-period sales), return on assets (net profit/average total assets) and return on equity (net profit/average shareholders’ equity). Analysts should adjust for one-off items and examine the source of growth.

1. Operational efficiency: How productively are assets and liabilities managed? Examples include inventory turnover (cost of sales/average inventory), days receivable (average accounts receivable/[sales/365]) and days payable (average accounts payable/[cost of goods sold/365]). Average balances are generally preferable when the statement-of-financial-position date is unrepresentative.

1. Liquidity: Can the company meet near-term obligations? Common measures include the current ratio (current assets/current liabilities) and quick ratio (cash + marketable securities + accounts receivable/current liabilities). Classification, restricted cash, inventory convertibility and available credit affect interpretation.

1. Leverage or gearing: How much debt financing does the firm use and how comfortably can it service that debt? Examples include debt-to-equity (defined debt/equity) and interest coverage (EBIT/interest expense). Define debt consistently and examine maturities, covenants and cash-flow coverage as well as the ratio.

These formulas are conventions, not universal laws. Data providers and industries may define the same label differently. State each numerator, denominator, period and accounting adjustment before comparing results.

How to use it

Start with a decision question and obtain reliable, comparable financial statements and notes. Reconcile accounting policies, currencies, fiscal periods, acquisitions, discontinued operations and unusual items. Calculate a focused set of ratios, retain the underlying values and review several periods rather than one point.

Using the table above produces the following comparison:

Firm A generates the most revenue, while Firm B appears more liquid, efficient and profitable on the selected measures. That pattern may make Firm B a candidate industry leader, but the conclusion must be tested against cash flow, business mix, risk, capital intensity, market position and accounting choices.

Compare each ratio in three directions: with the company’s own history, with genuinely comparable peers and with the economics required by its strategy. Decompose surprising results into their drivers. A stronger return on equity, for example, can come from better margins, faster asset use or more leverage—very different explanations with different risk.

Top practical tip

Use a compact, decision-relevant set of ratios and trace every outlier back to the statements and notes. Ratios are diagnostic prompts: the valuable output is an evidence-based explanation of what changed, why and whether it is sustainable.

Top pitfall

Do not compare precise ratios built from incomparable inputs. Different fiscal year-ends, accounting policies, business mixes, currencies and exceptional transactions can overwhelm the signal. More ratios do not automatically create a more accurate view; they can multiply the same data problem.

Further reading

• Penman, S.H. (twenty thirteen). Financial Statement Analysis and Security Valuation. McGraw-Hill.
• Palepu, K.G., Healy, P.M. and Peek, E. (twenty thirteen). Business Analysis and Valuation. Cengage Learning.