Professor Jessie

Why Ratio Analysis Matters

Raw financial statements are like a pile of puzzle pieces — the information is there, but it's hard to see the picture. Ratio analysis assembles those pieces into something meaningful. By calculating and interpreting financial ratios, we can assess a firm's performance, compare it to competitors, and identify what needs improvement.

Five Categories of Ratios

• Liquidity ratios — Can the firm pay its short-term bills?
• Asset management ratios — How efficiently does the firm use its assets?
• Debt management ratios — How much leverage does the firm use, and can it handle it?
• Profitability ratios — How much profit does the firm generate from sales, assets, and equity?
• Market value ratios — What do investors think of the firm's future prospects?

Important Principles

A ratio number is not inherently good or bad. A current ratio of 3.0 might be excellent for a manufacturer but excessive for a retailer. Extreme values — whether high or low — can signal problems. And ratios are interconnected: changing one ratio often affects several others. Always begin analysis by evaluating the firm's overall picture, not individual ratios in isolation.

Liquidity Ratios: Can the Firm Pay Its Bills?

Liquidity ratios measure the relationship between a firm's current assets and current liabilities. They answer a simple but critical question: if all short-term obligations came due tomorrow, could the firm pay them?

The Three Key Liquidity Ratios

Each ratio gets progressively more conservative. The current ratio includes inventory, which may take months to sell. The quick ratio strips it out. The cash ratio strips out everything except cash itself.

Asset Management Ratios: How Efficient Is the Firm?

These ratios measure how well a firm uses its assets to generate sales. High turnover = efficient. Low turnover = assets sitting idle.

Inventory Management

• Inventory turnover = COGS ÷ Inventory — how many times inventory is sold and replaced per year
• Days' sales in inventory = 365 ÷ Inventory Turnover — average days inventory sits before being sold

Receivables Management

• Accounts receivable turnover = Net Sales ÷ Accounts Receivable — how efficiently the firm collects from customers
• Average collection period (ACP) = 365 ÷ AR Turnover — also called Days Sales Outstanding (DSO); how long customers take to pay

Payables Management

• Accounts payable turnover = COGS ÷ Accounts Payable
• Average payment period (APP) = 365 ÷ AP Turnover — how long the firm takes to pay suppliers

Asset and Capital Efficiency

• Fixed asset turnover = Sales ÷ Net Fixed Assets — sales generated per dollar of fixed assets
• Total asset turnover = Sales ÷ Total Assets — sales generated per dollar of all assets
• Capital intensity ratio = Total Assets ÷ Sales — the inverse of total asset turnover; how many dollars of assets are needed per dollar of sales

Debt Management Ratios: Leverage and Risk

These ratios measure two things: how much debt the firm uses relative to equity, and whether the firm can service that debt. There are two major types: capital structure ratios and coverage ratios.

Capital Structure Ratios

All three ratios measure essentially the same thing from slightly different angles. The less debt a firm uses, the lower all three ratios. Higher values mean more leverage — more risk, but potentially more return for equity holders.

The Relationship Between Them

These ratios are mathematically linked. If you know the debt ratio, you can derive the debt-to-equity and equity multiplier. They all tell the story of how the firm finances its assets — the balance between other people's money (debt) and owners' money (equity).

Coverage Ratios: Can the Firm Service Its Debt?

While capital structure ratios tell you how much debt the firm has, coverage ratios tell you whether the firm earns enough to actually pay the interest on that debt.

Three Coverage Ratios

• Times interest earned (TIE) = EBIT ÷ Interest Expense — dollars of operating earnings per dollar of interest obligation. A TIE of 4 means the firm earns 4× its interest costs.
• Fixed-charge coverage = (EBIT + Lease Payments) ÷ (Interest + Lease Payments) — broader measure including lease obligations as fixed charges
• Cash coverage ratio = (EBIT + Depreciation) ÷ Interest — uses operating cash flow rather than accounting earnings, since depreciation is a noncash expense

Profitability Ratios: The Bottom Line

Profitability ratios show the combined effect of liquidity, asset management, and debt management on the firm's overall results. These are closely monitored by investors — stock prices react strongly to profitability changes.

Profit Margins

• Gross profit margin = (Sales − COGS) ÷ Sales — percentage of sales left after direct production costs
• Operating profit margin = EBIT ÷ Sales — percentage left after all operating expenses
• Net profit margin = Net Income ÷ Sales — the percentage of every sales dollar that reaches the bottom line

Return Ratios

• Basic earnings power (BEP) = EBIT ÷ Total Assets — operating return on assets, before financing and tax effects
• Return on Assets (ROA) = Net Income ÷ Total Assets — overall return on all assets, including leverage and taxes
• Return on Equity (ROE) = Net Income ÷ Stockholders' Equity — return on the shareholders' investment; the ultimate profitability metric

Dividend Policy

• Dividend payout ratio = Dividends ÷ Net Income — percentage of earnings paid as cash dividends

A high ROE is usually desirable, but it can be inflated by high leverage. A firm with massive debt might show a great ROE because the equity base is tiny — but that doesn't mean it's a healthy firm. Always look at ROE alongside debt ratios.

Market Value Ratios: What Investors Think

Market value ratios connect the firm's financial statements to its stock price. They measure what investors think about the company's future performance and risk.

Price-Earnings (P/E) Ratio

P/E Ratio = Market Price per Share ÷ Earnings per Share. This is the most famous market value ratio — quoted constantly in financial media. It tells you how much investors will pay for each dollar of earnings. A high P/E suggests investors expect strong future growth. A low P/E might indicate a bargain — or a company with problems.

Market-to-Book Ratio

Market-to-Book = Market Value per Share ÷ Book Value per Share. This compares what investors think the firm is worth to what the balance sheet says it's worth. A ratio above 1.0 means the market values the firm above its accounting book value — reflecting intangible assets, growth potential, or brand value that GAAP doesn't capture.

DuPont Analysis: Decomposing ROE

The DuPont system breaks ROE into its component parts, revealing what's really driving a firm's return on equity. This is one of the most powerful analytical tools in finance.

The DuPont Identity

Or equivalently:

What Each Component Reveals

• Profit margin — How efficiently the firm converts sales to profit (operating efficiency)
• Asset turnover — How efficiently the firm uses assets to generate sales (asset efficiency)
• Equity multiplier — How much leverage the firm uses (financing strategy)

Two firms with identical ROE can arrive there through completely different paths. One might have high margins and low leverage (a premium brand with conservative financing). Another might have low margins but high turnover and high leverage (a discount retailer using debt aggressively). DuPont analysis reveals which lever is driving returns.

Internal and Sustainable Growth Rates

How fast can a firm grow without external financing? These two rates answer that question from different angles.

Internal Growth Rate

The maximum growth rate achievable using only internal financing — retained earnings, no new debt or equity.

Sustainable Growth Rate

The maximum growth rate achievable while maintaining the firm's current capital structure — using retained earnings and proportional new debt, but no new equity.

The retention ratio is the percentage of earnings kept (1 − dividend payout ratio). A firm that pays out all earnings as dividends has a retention ratio of 0% and cannot grow internally at all.

Benchmarking: Time Series and Cross-Sectional Analysis

A ratio by itself is just a number. To interpret it, you need a benchmark — something to compare against.

Two Types of Benchmark Analysis

Common-Size Statements

Another benchmarking technique: "spreading" the financial statements by dividing all balance sheet items by total assets and all income statement items by net sales. This produces common-size statements that make firms of different sizes directly comparable. A $10 billion firm and a $100 million firm can be compared line by line because everything is expressed as a percentage.

Cautions When Using Financial Ratios

Ratios are powerful, but they have limitations. Here's what to watch for:

• Historical data ≠ future performance — Ratios use past data. The world can change quickly. Yesterday's strong ratios don't guarantee tomorrow's success.
• Different accounting methods — Firms using different depreciation methods, inventory valuation (FIFO vs. LIFO), or revenue recognition rules can look very different even with similar operations.
• International competitors — Foreign firms may follow different accounting standards (IFRS vs. GAAP), making comparisons tricky.
• Industry differences — Comparing a bank's ratios to a manufacturer's is meaningless. Always compare within the same industry.
• Seasonality — Some businesses are highly seasonal. A retailer's inventory turnover in November looks very different from February. Compare same-period data.
• Window dressing — Managers may time transactions to make end-of-period ratios look better. Pay attention to trends, not just snapshots.

Key Takeaways

• Ratio analysis transforms raw financial statement data into actionable insight
• Five ratio categories: liquidity, asset management, debt management, profitability, and market value
• No single ratio is inherently good or bad — always interpret in context
• Liquidity ratios: current, quick, and cash — each progressively more conservative
• Asset management ratios measure how efficiently assets generate sales
• Debt management has two sides: capital structure (how much debt) and coverage (can the firm pay it)
• DuPont analysis decomposes ROE into margin × turnover × leverage — revealing what drives returns
• Sustainable growth rate = the fastest a firm can grow without changing its capital structure
• Always benchmark using both time series and cross-sectional analysis
• Ratios based on historical data have limitations — use them critically