Ratio Analysis: A Practical Guide What is ratio analysis? Ratio analysis uses figures from a company's financial statements to evaluate its liquidity, efficiency, profitability, and solvency. Rather than a single metric, it is a toolkit of relationships (ratios) that help investors, managers, and creditors assess performance, compare firms, and track trends over time. Why it matters
* Converts raw financial data into interpretable measures.
* Helps identify strengths, weaknesses, and trends that raw totals may hide.
* Supports comparisons across time, among peers, and against internal or external benchmarks.
* Commonly used in lending decisions, valuation, and operational reviews.
How ratio analysis works
* Ratios are calculated from items on the balance sheet, income statement, cash-flow statement, and equity statement.
* They are most useful when compared to:
* Historical values for the same company (trend analysis).
* Industry peers or sector averages (comparative analysis).
* Predefined targets or covenant thresholds (benchmarking).
* Use multiple ratios together; no single ratio gives a complete picture.
Key limitations
* Can be distorted by accounting policies, seasonality, one‑time events, or short-term actions that change ratios without changing fundamentals.
* Industry differences make absolute comparisons misleading—interpret ratios in context.
* Ratios are descriptive, not predictive; they require qualitative and forward-looking analysis to infer future performance.
* Vulnerable to manipulation through timing, classification, or accounting choices.
Main types of ratios (with examples)
1. Liquidity ratios — ability to meet near‑term obligations
2. Current ratio = Current assets / Current liabilities
3. Quick ratio (acid-test) = (Current assets − Inventory) / Current liabilities
4. Working capital = Current assets − Current liabilities Explore More Resources

  5. Solvency (leverage) ratios — long-term capital structure and debt risk
  6. Debt-to-equity = Total debt / Shareholders’ equity
  7. Debt-to-assets = Total debt / Total assets
  8. Interest coverage = EBIT / Interest expense Explore More Resources




  9. Profitability ratios — ability to produce earnings
  10. Net profit margin = Net income / Revenue
  11. Gross margin = Gross profit / Revenue
  12. Return on assets (ROA) = Net income / Total assets
  13. Return on equity (ROE) = Net income / Shareholders’ equity Explore More Resources




  14. Efficiency (activity) ratios — how well assets are used to generate sales
  15. Asset turnover = Revenue / Total assets
  16. Inventory turnover = Cost of goods sold / Average inventory
  17. Days sales outstanding (DSO) = Receivables / Average daily sales Explore More Resources




  18. Coverage ratios — capacity to service debt and fixed obligations
  19. Times interest earned = EBIT / Interest expense
  20. Debt-service coverage ratio = Operating cash flow / Debt service Explore More Resources




  21. Market (valuation) ratios — investor-oriented measures of value and return
  22. Price-to-earnings (P/E) = Market price per share / Earnings per share
  23. Earnings per share (EPS)
  24. Dividend yield = Annual dividends per share / Market price per share
  25. Dividend payout ratio = Dividends / Net income

How to apply ratio analysis
* Over time (trend analysis): calculate a ratio at regular intervals to detect direction, rate of change, and seasonality effects.
* Tip: adjust for seasonality and cyclical business effects before drawing conclusions.
* Across peers (comparative analysis): compare with companies in the same industry and of similar size/capital structure.
* Ensure comparisons use consistent accounting conventions and consider business model differences.
* Against benchmarks: use internal targets or external covenants (e.g., lender-required coverage ratios) to monitor compliance and strategy.
Practical examples
* Profit margin comparison: Company A has a net margin of 50% and Company B 10%. All else equal, A converts far more revenue into profit. If A’s P/E is 100 and B’s is 10, investors are assigning much higher future growth or quality to A.
* Inventory turnover: Tracking monthly inventory turnover reveals whether inventory management is improving or deteriorating and helps diagnose slow-moving stock or supply‑chain issues.
Best practices
* Use a battery of ratios from different categories rather than relying on one metric.
* Understand the drivers behind a ratio—changes in revenue, margins, asset levels, or accounting policy can all affect results.
* Normalize for one‑time items and nonrecurring events when comparing periods.
* Interpret ratios in the context of industry norms, company lifecycle stage, and economic conditions.
* Pair quantitative ratio analysis with qualitative assessment (management, strategy, market position).
Conclusion Ratio analysis distills financial statements into actionable measures that clarify a company’s financial condition and performance trends. When used thoughtfully—combined across ratio types, adjusted for context, and supplemented with qualitative judgement—it is a powerful tool for investors, managers, and creditors. Explore More Resources