What is Ratio Analysis?
Ratio analysis is the systematic examination of financial statements by computing the relationship between key figures, revealing a company's efficiency, profitability, and financial health.
Ratio analysis compares financial metrics (revenue, profit, assets, liabilities) to assess profitability, liquidity, and efficiency. Key types: current ratio, debt-to-equity, and ROE.
- •Current Ratio = Current Assets / Current Liabilities
- •Quick Ratio = (Current Assets − Inventory) / Current Liabilities
- •Measures ability to pay short-term debts
- •ROE = Net Income / Equity
- •Profit Margin = Net Income / Revenue
- •Measures how well earnings are generated
Step-by-step worked examples
Company A: Current Assets $50K, Current Liabilities $25K. Current Ratio?
Current Ratio = Current Assets / Current Liabilities = 50,000 / 25,000 = 2.0 → For every $1 of liabilities, $2 in liquid assets
Company B: Net Income $100K, Revenue $500K. Profit Margin?
Profit Margin = Net Income / Revenue = 100,000 / 500,000 = 0.20 = 20% → 20¢ profit on every $1 of sales
Company C: Total Debt $300K, Equity $200K. Debt-to-Equity Ratio?
Debt-to-Equity = Total Debt / Equity = 300,000 / 200,000 = 1.5 → $1.50 debt for every $1 of equity
Flashcards
Quick quiz
Q1.Current Ratio = Current Assets / Current Liabilities. What does it measure?
Q2.Profit Margin = 25%. Interpretation?
Q3.High Debt-to-Equity Ratio indicates…
Q4.Which ratio is most relevant for assessing bankruptcy risk?
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Common mistakes
High profit margin always means high ROI. — Correct: Profit margin measures profitability; ROI includes the amount invested, not just profit percent.
A current ratio above 1 is always bad. — Correct: Ratios above 1 show liquidity; too high may mean poor asset utilization, too low means risk.
Ratios alone tell the complete story. — Correct: Ratios must be compared to industry benchmarks and historical trends.
All companies in the same industry have similar ratios. — Correct: Ratios vary by business model, size, and strategy; industry average is a reference, not a rule.
FAQ
What are financial ratios used for?
Evaluate profitability, efficiency, liquidity, and solvency. Investors, creditors, and managers use them to assess company health.
What is a good current ratio?
Between 1.5 and 3.0 is typical; too low means liquidity risk, too high may mean poor asset management.
How do you compare ratios across companies?
Use industry benchmarks and historical trends; ratios only make sense in context.
Why is debt-to-equity ratio important?
It shows financial leverage and risk; higher ratios mean more debt and greater bankruptcy risk.