What is Financial Ratio Analysis?
Financial ratio analysis uses simple mathematical relationships between balance sheet and income statement figures to evaluate a company's health, profitability, efficiency and risk. Investors, creditors and managers rely on ratios to make fast, data-driven decisions.
A financial ratio is a comparison of two accounting numbers (e.g. profit ÷ equity). Ratios reveal patterns hidden in raw numbers: profitability (ROE, ROI), liquidity (current ratio), efficiency (asset turnover) and solvency (debt-to-equity). High quality analysis combines multiple ratios across time and peers.
- •ROE = Net Income / Equity
- •ROI = Net Income / Assets
- •Gross Margin = (Revenue − COGS) / Revenue
- •Current Ratio = Current Assets / Current Liabilities
- •Debt-to-Equity = Total Debt / Equity
- •Interest Coverage = EBIT / Interest Expense
Step-by-step worked examples
Company A: Net income €50K, equity €200K. What is ROE?
ROE = Net Income / Equity ROE = 50K / 200K = 0.25 = 25% Interpretation: €1 of shareholder capital generated €0.25 profit.
Company B: Current assets €80K, current liabilities €40K. Current ratio?
Current Ratio = 80K / 40K = 2.0 Interpretation: Can cover short-term debt 2× over; generally healthy (ratio 1.5–3 is normal).
Company C: EBIT €100K, interest expense €10K. Interest coverage ratio?
Interest Coverage = 100K / 10K = 10 Interpretation: Earns enough to pay interest 10 times; low risk of default (>2.5 is safe).
Flashcards
Quick quiz
Q1.A company has net income €100K and total assets €500K. ROA (Return on Assets) is…
Q2.Which ratio does NOT measure profitability?
Q3.A current ratio of 0.8 means…
Q4.Why compare a company's ratios to its industry peers?
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Common mistakes
Using only one ratio to judge a company. — Correct: Analyze profitability, liquidity, efficiency and solvency together — no single ratio tells the full story.
Ignoring the company's industry and past trends. — Correct: Compare ratios to peers and track them over 3–5 years to spot improvement or decline.
A high ROE always means good management. — Correct: High ROE with high debt is risky (leverage inflates returns but increases risk).
Current ratio > 3 is always good. — Correct: Too high suggests idle cash; 1.5–2.5 is often optimal (depends on industry and cash needs).
FAQ
What are the main types of financial ratios?
Profitability (ROE, ROI, margin), liquidity (current, quick ratio), efficiency (asset turnover) and solvency (debt-to-equity, interest coverage).
How do I calculate ROE?
ROE = Net Income / Shareholders' Equity. Shows profit per euro of shareholder investment; compare to industry average.
What does a current ratio of 1.5 mean?
Current assets are 1.5 times current liabilities — the company can cover short-term debt 1.5× over; generally healthy.
Is a high debt-to-equity ratio always bad?
Not necessarily; it depends on the industry, interest rates and cash flow. Tech firms often use debt. Compare to peers.