Financial ratio analysis reduces a company’s financial statements to comparable numbers — ratios — that can be compared across years or against industry norms. A single dollar amount doesn’t say much ($50M in inventory is a lot for a small retailer, almost nothing for Walmart). A ratio normalises away scale.
Ratios fall into four groups, mirroring the four financial objectives of Financial management and Assessing financial strength:
Liquidity ratios — ability to meet short-term obligations
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Working capital = Current Assets − Current Liabilities. Dollar amount, not really a ratio. Should be positive — a negative working capital means short-term obligations exceed short-term resources.
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Current ratio = Current Assets / Current Liabilities. The relativistic version of working capital. Rule of thumb: aim for ≥ 2, certainly above 1.
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Acid-test ratio (quick ratio) = Quick Assets / Current Liabilities, where quick assets exclude inventories — only the assets that can become cash immediately. Rule of thumb: aim for ≥ 1.
Profitability ratios — ability to generate profit
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Profit margin = Net Income / Sales. How much of each sales dollar ends up as profit. The headline profitability number.
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Return on Assets (ROA) = Net Income / Total Assets. How efficiently the company’s asset base produces income. (ROA straddles profitability and efficiency — it appears in this group because it measures dollars of profit per dollar of assets, but it is also a standard efficiency metric since it captures asset productivity.)
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Return on Equity (ROE) = Net Income / Total Equity. The return owners earn on their stake. Often the most-watched number by investors.
ROE > ROA is normal (because the firm uses leverage). The gap measures financial leverage’s contribution to equity returns.
Efficiency ratios — ability to use assets productively
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Inventory turnover = Sales / Inventory (this course’s convention). How quickly inventory is sold and replaced. High turnover means inventory isn’t sitting around; low turnover suggests too much inventory relative to sales. Standard accounting uses COGS / Average Inventory instead — this is the same idea but at cost basis rather than market price, and is the form to use when comparing against published industry data.
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Asset turnover = Sales / Total Assets. How many dollars of sales each dollar of assets generates. Pairs naturally with profit margin: , the DuPont decomposition. A capital-intensive business (utility, steel mill) lives on low asset turnover with thick margins; a retailer lives on high asset turnover with thin margins.
Stability ratios — financial structure / leverage
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Debt ratio = Total Debt / Total Assets. What fraction of the asset base is financed by debt. Low = good (low risk); high = leveraged (more risk but potentially more return).
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Debt-to-equity = Total Debt / Owner’s Equity. Investors’ view: for each dollar of equity, how much debt is being carried. High D/E means stockholders will not be made whole in bankruptcy.
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Equity ratio = Total Equity / Total Assets. Mirror image of the debt ratio (Equity ratio + Debt ratio ≈ 1).
Ratio analysis comparison
Good signs:
- Rising profit margins year over year.
- Stable current and quick ratios (no liquidity squeeze).
- Decreasing debt ratios (less leverage over time).
Bad signs:
- Low pro forma ratios (the projections aren’t strong).
- Low return on assets (assets aren’t producing returns).
- Trends moving the wrong way.
Rules of thumb (general benchmarks):
- Current ratio ≈ 2.
- Acid-test ratio ≈ 1.
But: specific values are themselves neither good nor bad — what matters is what they imply in context. A current ratio of 5 might mean liquid strength, or it might mean piles of unused cash that should be invested. A debt ratio of 0.8 is high for most businesses but normal for utilities and banks. Always compare against industry norms before drawing conclusions.
For the four-objective framing this grouping mirrors, see Financial management (profitability / liquidity / efficiency / stability) and Assessing financial strength. For the source statements see Income statement, Balance sheet, Statement of cash flows.