Financial Statement Analysis Ratios

Why This Matters

Financial statement analysis ratios are the diagnostic tools you'll use throughout your accounting career—and they're heavily tested because they reveal how well you understand the relationships between financial statement line items. You're not just being asked to memorize formulas; you're being tested on whether you can interpret what ratios reveal about a company's liquidity, solvency, profitability, and efficiency. These four categories form the backbone of financial analysis, and understanding which ratios belong to which category is essential for exam success.

The key insight is that ratios transform raw numbers into comparable metrics. A company with $10 million in net income isn't necessarily more profitable than one with $1 million—it depends on the assets, equity, or revenue generating that income. When you encounter ratio questions, ask yourself: What am I measuring in the numerator? What am I comparing it to in the denominator? And what story does that relationship tell? Don't just memorize formulas—know what financial health dimension each ratio illuminates.

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Liquidity Ratios: Can the Company Pay Its Bills?

Liquidity ratios measure a company's ability to meet short-term obligations as they come due. The core principle is matching liquid resources against near-term liabilities—the more liquid the assets included, the more conservative the measure.

Current Ratio

• Formula: $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$—the broadest measure of short-term liquidity
• Benchmark of 1.0 means current assets exactly cover current liabilities; most healthy companies target 1.5 to 2.0
• Includes all current assets, even slow-moving inventory, making it less conservative than the quick ratio

Quick Ratio (Acid-Test Ratio)

• Formula: $\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$—excludes inventory because it's the least liquid current asset
• More stringent test of immediate liquidity; a ratio above 1.0 indicates the company can pay obligations without selling inventory
• Critical for industries with slow-moving or obsolete inventory risk, like retail or manufacturing

Operating Cash Flow Ratio

• Formula: $\text{Operating Cash Flow Ratio} = \frac{\text{Operating Cash Flow}}{\text{Current Liabilities}}$—uses actual cash generated, not accrual-based assets
• Ratio above 1.0 confirms the company generates enough operating cash to cover short-term obligations
• Bridges the income statement and balance sheet by incorporating cash flow statement data—a favorite for integrated analysis questions

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Solvency Ratios: Can the Company Survive Long-Term?

Solvency ratios assess a company's capital structure and ability to meet long-term obligations. These ratios reveal how much financial risk a company has taken on through debt financing versus equity financing.

Debt-to-Equity Ratio

• Formula: $\text{Debt-to-Equity} = \frac{\text{Total Liabilities}}{\text{Total Equity}}$—measures the proportion of debt versus owner investment
• Higher ratios indicate greater financial leverage and risk; creditors prefer lower ratios for safety
• Industry context matters—capital-intensive industries like utilities typically carry higher ratios than tech companies

Interest Coverage Ratio

• Formula: $\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}}$—measures how many times over a company can pay its interest obligations
• Higher ratios reduce default risk; a ratio below 1.5 raises red flags for creditors
• Uses EBIT (earnings before interest and taxes) because interest is paid from pre-tax operating income

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Profitability Ratios: Is the Company Making Money?

Profitability ratios measure how effectively a company converts revenue, assets, or equity into profit. These ratios answer the fundamental question: Is this business generating adequate returns for its stakeholders?

Gross Profit Margin

• Formula: $\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Total Revenue}}$—measures profitability before operating expenses
• Reflects pricing power and production efficiency; higher margins indicate better control over cost of goods sold
• First line of defense—if gross margin is weak, net profit margin will almost certainly suffer

Net Profit Margin

• Formula: $\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Total Revenue}}$—the "bottom line" profitability measure
• Captures all expenses including operating costs, interest, and taxes; shows what percentage of each revenue dollar becomes profit
• Best overall profitability indicator for comparing companies within the same industry

Return on Assets (ROA)

• Formula: $\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}}$—measures how efficiently assets generate profit
• Higher ROA indicates better asset utilization; useful for comparing companies with different sizes
• Combines profitability and efficiency—a company can improve ROA by either increasing margins or reducing asset base

Return on Equity (ROE)

• Formula: $\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}}$—measures return generated for equity investors
• Key metric for shareholders; indicates how effectively management uses invested capital
• Can be artificially inflated by high debt levels—always analyze alongside debt-to-equity ratio

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Efficiency Ratios: How Well Are Resources Being Used?

Efficiency ratios (also called activity ratios) measure how effectively a company manages its operating assets. These ratios convert balance sheet items into turnover metrics, showing how quickly assets cycle through the business.

Inventory Turnover Ratio

• Formula: $\text{Inventory Turnover} = \frac{\text{COGS}}{\text{Average Inventory}}$—measures how many times inventory is sold and replaced annually
• Higher turnover indicates efficient inventory management and strong sales; low turnover suggests overstocking or obsolescence risk
• Uses COGS, not revenue, because inventory is carried at cost, not selling price

Accounts Receivable Turnover Ratio

• Formula: $\text{A/R Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$—measures collection efficiency
• Higher turnover means faster collection and better cash flow; can also calculate days sales outstanding by dividing 365 by this ratio
• Reflects credit policy effectiveness—too high might indicate overly restrictive credit terms that hurt sales

Asset Turnover Ratio

• Formula: $\text{Asset Turnover} = \frac{\text{Total Revenue}}{\text{Average Total Assets}}$—measures how efficiently total assets generate sales
• Higher ratio indicates effective asset utilization; particularly important for asset-heavy industries
• Component of the DuPont analysis—connects to ROE through the formula: $\text{ROE} = \text{Net Profit Margin} \times \text{Asset Turnover} \times \text{Equity Multiplier}$

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Market Ratios: What Do Investors Think?

Market ratios connect accounting data to stock market performance, helping investors assess valuation and returns. These ratios bridge internal financial reporting with external market perceptions.

Earnings Per Share (EPS)

• Formula: $\text{EPS} = \frac{\text{Net Income}}{\text{Outstanding Shares}}$—allocates profit to each common share
• Primary measure of per-share profitability; forms the denominator of the P/E ratio
• Watch for diluted EPS on exams, which accounts for convertible securities and stock options

Price-to-Earnings (P/E) Ratio

• Formula: $\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}$—reflects investor expectations for future growth
• Higher P/E suggests investors expect growth or that the stock may be overvalued; lower P/E may indicate undervaluation or low growth expectations
• Compare within industries—a tech company's P/E of 30 may be reasonable while a utility's P/E of 30 signals overvaluation

Dividend Payout Ratio

• Formula: $\text{Dividend Payout} = \frac{\text{Dividends per Share}}{\text{EPS}}$—shows what portion of earnings goes to shareholders
• Lower ratios indicate reinvestment focus (growth companies); higher ratios suggest mature companies returning profits
• Retention ratio is the complement: $1 - \text{Dividend Payout Ratio}$—the portion reinvested in the business

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Quick Reference Table

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Self-Check Questions

1. Which two liquidity ratios would you compare to assess whether a company's inventory is masking liquidity problems, and what would a significant difference between them indicate?

2. A company has ROE of 18% and ROA of 6%. What does this discrepancy reveal about the company's capital structure, and which ratio would you examine to confirm your hypothesis?

3. If an FRQ asks you to evaluate a company's ability to meet both short-term and long-term obligations, which four ratios would provide the most comprehensive analysis?

4. Compare and contrast gross profit margin and net profit margin. If a company's gross margin is stable but net margin is declining, what does this suggest about the source of profitability problems?

5. A retail company reports inventory turnover of 4x while its competitor reports 12x. Beyond "better inventory management," what specific operational or strategic factors might explain this difference, and how would you investigate further using other ratios?