This lesson provides an in-depth examination of ratio analysis, the most widely used technique for evaluating financial performance and position. It covers the major categories of ratios, their calculation, interpretation, and limitations.

• Introduction to Ratio Analysis: Ratio analysis is a quantitative technique for evaluating a company’s performance and financial position by comparing relationships between different financial statement items. Ratios are indicators of some aspect of a company’s performance, but they tell what happened, not why it happened . Evaluations require comparisons—it is difficult to say a company’s performance was “good” or “bad” without a basis for comparison, such as cross-sectional analysis (comparing multiple companies) or trend analysis (comparing measures over time) .

• Categories of Financial Ratios: Financial ratios are typically grouped into the following categories :

  • Profitability Ratios: Measure the company’s ability to generate profits from its operations and investments. Major ratios include gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).

  • Liquidity Ratios: Measure the company’s ability to meet short-term obligations. Major ratios include the current ratio, quick (acid-test) ratio, cash ratio, and the cash conversion cycle.

  • Solvency Ratios (Leverage): Measure the company’s ability to meet long-term obligations and its reliance on debt. Major ratios include debt-to-assets ratio, debt-to-equity ratio, financial leverage ratio, and interest coverage.

  • Activity Ratios (Efficiency): Measure the efficiency of the company’s operations and asset utilization. Major ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, and total asset turnover.

  • Valuation Ratios: Compare the company’s market value to its financial performance. Includes Price-to-Earnings (P/E) ratio and Enterprise Value multiples .

• DuPont Analysis: The DuPont system breaks down Return on Equity (ROE) into components that are indicators of different aspects of company performance . The five-component DuPont decomposition expresses ROE as a function of:

  1. Tax Rate

  2. Interest Burden

  3. Operating Profitability

  4. Efficiency (Asset Turnover)

  5. Financial Leverage

This decomposition helps analysts identify whether improvements or declines in ROE are driven by operating performance, efficiency, or financial leverage .

• Industry-Specific Ratios: Because aspects of performance considered important in one industry may be irrelevant in another, industry-specific ratios are used to reflect these differences . For example, retail businesses focus heavily on inventory turnover, while financial institutions focus on capital adequacy and interest margins.