Financial Ratio Analysis
Ratio analysis turns raw statement figures into comparable measures across four families. Liquidity ratios such as the current ratio test whether short-term bills can be met. Leverage ratios such as debt-to-equity gauge reliance on borrowing and financial risk. Operating-efficiency ratios such as asset turnover show how hard the asset base works. Profitability ratios such as return on equity measure the return wrung from sales and capital. A ratio means little alone. Its power comes from cross-company comparison against peers and time-series comparison against the firm’s own history.
Why it matters
A single number like net income tells you little until you scale it. Earning A$10m on A$50m of equity is excellent, on A$5b it is poor. Ratios do that scaling, and the famous DuPont decomposition shows return on equity is just margin times turnover times leverage. The discipline is always to compare. A ratio next to a close competitor and next to the same firm three years ago turns a lone figure into a judgement.
A company’s debt-to-equity ratio mainly measures its
Formulas
Worked examples
A firm has net income of A$60m, sales of A$600m, total assets of A$500m and equity of A$300m. Compute net margin, asset turnover and ROE, and interpret with DuPont.
Net margin is A$60m over A$600m, which is 10 percent. Asset turnover is A$600m over A$500m, which is 1.2 times. Return on equity is A$60m over A$300m, which is 20 percent. DuPont confirms this. Margin of 0.10 times turnover of 1.2 times the equity multiplier (A$500m over A$300m, about 1.67) equals roughly 0.20. The decomposition shows the 20 percent ROE rests on solid margin, decent efficiency and moderate leverage rather than heavy borrowing.
Common mistakes
- ✗A single ratio reveals whether a company is healthy. A ratio is only meaningful against peers and against the firm’s own past. In isolation it can mislead.
- ✗A higher current ratio is always better. An unusually high current ratio can signal idle cash or bloated inventory, which is inefficient rather than safe.
- ✗Ratios are comparable across any two companies. Accounting choices and industry norms differ, so comparisons are valid mainly within an industry and on a consistent basis.
- ✗High ROE always means a great business. ROE can be inflated by heavy leverage. DuPont separates genuine operating performance from a borrowing-driven boost.
Revision bullets
- •Four families: liquidity, leverage, operating efficiency, profitability
- •Liquidity tests short-term solvency, leverage tests financial risk
- •Efficiency shows asset productivity, profitability shows returns earned
- •Compare cross-company against peers and time-series against history
- •DuPont splits ROE into margin, turnover and leverage
- •Compare within an industry and on a consistent accounting basis
Quick check
A company’s debt-to-equity ratio mainly measures its
Under the DuPont identity, return on equity is the product of net margin, asset turnover and
Connected topics
More in Fundamental Analysis
Sources
- Brailsford, Heaney & Bilson (2015), Ch. 12Brailsford, T., Heaney, R., & Bilson, C. Investments: Concepts and Applications. 5th ed. Cengage Learning Australia, 2015.Sets out the liquidity, leverage, efficiency and profitability ratio families and comparative analysis.
- Bodie, Kane & Marcus (2021), Ch. 19Bodie, Z., Kane, A., & Marcus, A. J. Investments. 12th ed. McGraw-Hill Education, 2021.Reference treatment of financial-statement ratios and the DuPont decomposition of ROE.