Accounting & analysis
Ratio analysis
Ratios turn statements into comparable signals of profitability, liquidity, leverage, and efficiency.
Definition
A ratio divides one financial quantity by another to make performance comparable across time and across companies of different size. Profitability ratios measure margin and return; liquidity ratios measure short-term coverage; leverage ratios measure debt burden; efficiency ratios measure how hard assets and working capital work.
A ratio is a question, not an answer. It tells you where to look, and it only becomes meaningful next to a trend, a peer, or a benchmark.
Intuition
One number in isolation is noise. A ratio puts two numbers in conversation, and the direction of travel is usually more informative than the level.
When to use it
- Comparing companies of different sizes, or one company across years.
- Triaging a set of statements to find the area that needs attention.
When not to use it
- Comparing ratios across industries with different capital intensity and margins.
- Drawing a conclusion from a single ratio with no trend or benchmark.
Formula
Current ratio
Current assets ÷ Current liabilities
Formula
Debt to equity
Total debt ÷ Equity
Formula
Net margin
Net income ÷ Revenue
Formula
Asset turnover
Revenue ÷ Total assets
Worked example
Two ratios, one balance sheet
Current assets 480,000; current liabilities 300,000; total debt 900,000; equity 1,200,000.
- 1
Liquidity
Current ratio = 480,000 ÷ 300,000 = 1.6.
- 2
Leverage
Debt to equity = 900,000 ÷ 1,200,000 = 0.75.
The firm holds 1.60 of short-term assets per unit of short-term debt and 0.75 of debt per unit of equity, which is unremarkable but not alarming.
Measured by
These scoreboard metrics track or interpret this idea across the Lab.
Common mistakes
- Using average balances and closing balances interchangeably within one comparison.
- Treating a high current ratio as healthy when it is driven by unsellable inventory.
- Mixing book values and market values inside one ratio.
How it connects
is an advanced form of
The source extends the target once the basics are secure.
relates to
Useful to study together, in either order.
is measured by
The target is the metric or diagnostic for the source.