Ratio analysis
Ratios summarise financial relationships in a single number, revealing liquidity, efficiency, solvency, and profitability.
Liquidity ratios
Liquidity ratios measure ability to meet short-term obligations. Current ratio = current assets / current liabilities. Quick (acid-test) ratio = (cash + short-term investments + receivables) / current liabilities, excluding inventory and prepaid expenses. Very low ratios signal risk; very high ones may mean idle resources.
Efficiency ratios
Efficiency (activity) ratios measure how well assets are used. Accounts receivable turnover = net credit sales / average receivables; days sales outstanding = 365 / turnover. Inventory turnover = COGS / average inventory; days in inventory = 365 / turnover. Total asset turnover = net sales / average total assets.
Solvency ratios
Solvency ratios assess long-term survival and debt burden. Debt ratio = total liabilities / total assets. Debt-to-equity = total liabilities / total equity. Times interest earned = earnings before interest and taxes / interest expense. Higher debt magnifies returns in good times and risk in bad times.
Profitability ratios
Profitability ratios measure earnings relative to sales, assets, or equity. Gross margin = gross profit / net sales. Net profit margin = net income / net sales. Return on assets (ROA) = net income / average total assets. Return on equity (ROE) = net income / average equity.
Market ratios
Market ratios relate to share prices. Earnings per share = (net income - preferred dividends) / weighted average common shares. Price-to-earnings (P/E) = share price / EPS; a high P/E suggests investors expect strong growth. Dividend yield = dividends per share / share price.
The DuPont analysis
DuPont analysis breaks ROE into three parts: net profit margin x total asset turnover x equity multiplier (average assets / average equity). It shows whether a high ROE comes from strong margins, efficient asset use, or heavy borrowing, which matters greatly for judging quality and risk.
Cash flow ratios and quality of earnings
Comparing operating cash flow with net income helps judge earnings quality: if net income rises while operating cash flow falls, profits may depend on aggressive accounting or growing receivables. Free cash flow (operating cash flow - capital expenditures) shows cash available for debt repayment, dividends, and growth.
Worked example
A firm has net income of 60,000 dollars, net sales of 600,000, average assets of 400,000, and average equity of 200,000. Net margin = 10%; asset turnover = 1.5; equity multiplier = 2. ROE = 10% x 1.5 x 2 = 30%, matching 60,000 / 200,000. Half of this strong ROE comes from leverage, which also raises risk.
Key takeaways
Liquidity ratios (current, quick) test short-term obligations. Efficiency ratios (receivables, inventory, and asset turnover) measure asset use. Solvency ratios (debt ratio, debt-to-equity, times interest earned) assess debt burden. Profitability ratios include margins, ROA, and ROE. Market ratios include EPS, P/E, and dividend yield. DuPont analysis splits ROE into margin, turnover, and leverage. Comparing cash flow with net income tests earnings quality.
Flashcard
Current assets / current liabilities
Check your understanding
Using DuPont analysis, a company has a 5% net margin, asset turnover of 2, and an equity multiplier of 3. What is its ROE?