Semester 5 / Business Economics and Financial Accounting / Accounting / Ratio Analysis

Ratio Analysis

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6 min read Last updated Thu Aug 20 2026 05:25:53 GMT+0000 (Coordinated Universal Time)
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Ratio analysis computes and interprets the relationship between 2 related or interdependent components of financial statements over an accounting period, to evaluate a company’s operations, profitability, liquidity, solvency, and efficiency.

Ratios are compared against industry benchmarks, historical data, or competitors to assess relative performance.

Liquidity Ratios

Assess a company’s ability to meet short-term obligations using current assets or cash reserves.

Current Ratio

Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Higher ratio indicates a better short-term liquidity position. Excessively high ratio may indicate inefficient use of assets.

Quick Ratio

Aka. Acid-Rest Ratio. Modified version of Current Ratio, which inventory from current assets. Gives a more conservative liquidity measure.

Quick Ratio=Current Assets−InventoryCurrent Liabilities\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

Higher ratio suggests better short-term liquidity without relying on inventory sale.

Cash Ratio

The most conservative liquidity ratio, using only cash and cash equivalents against current liabilities.

Cash Ratio=Cash and Cash EquivalentsCurrent Liabilities\text{Cash Ratio} = \frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}}

Higher ratio indicates stronger ability to meet short-term liabilities using cash reserves.

Solvency Ratios

Assess a company’s ability to meet long-term debt obligations and overall financial stability.

Debt-to-Equity Ratio

Measures the proportion of total debt to shareholders’ equity.

Debt-to-Equity Ratio=Total DebtShareholders’ Equity\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}}

Higher ratio indicates greater financial leverage and risk.

Debt Ratio

Measures the proportion of total assets financed by debt.

Debt Ratio=Total DebtTotal Assets\text{Debt Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}}

Higher ratio suggests greater reliance on debt financing and risk of insolvency.

Interest Coverage Ratio

Evaluates a company’s ability to meet interest payments on outstanding debt.

Interest Coverage Ratio=EBITInterest Expense\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}}

EBIT stands for Earnings Before Interest and Taxes which means operating profit before deducting interest expense and income tax.

Higher ratio indicates a lower risk of default.

Efficiency Ratios

Aka. Activity or Asset Management Ratios. Measure how effectively a company manages its assets, liabilities, and resources.

Inventory Turnover Ratio

Measures how quickly a company sells and replaces its inventory.

Inventory Turnover Ratio=Cost of Goods SoldAverage Inventory\text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

Cost of Goods Sold (COGS) is the direct cost of producing or acquiring goods sold in the period. Average Inventory is the average of the beginning and ending inventory levels.

Higher ratio suggests efficient inventory management and minimized carrying costs. Extremely high ratio may indicate stockouts.

Days Sales of Inventory

Number of days it takes to sell inventory.

Days Sales of Inventory=365Inventory Turnover Ratio\text{Days Sales of Inventory} = \frac{365}{\text{Inventory Turnover Ratio}}

Lower value suggests faster inventory turnover.

Accounts Receivable Turnover Ratio

Evaluates how efficiently a company collects receivables from customers.

Accounts Receivable Turnover Ratio=Net Credit SalesAverage Accounts Receivable\text{Accounts Receivable Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}

Lower value suggests faster inventory turnover.

Days Sales Outstanding

Average number of days to collect payment from customers.

Days Sales Outstanding=365Accounts Receivable Turnover Ratio\text{Days Sales Outstanding} = \frac{365}{\text{Accounts Receivable Turnover Ratio}}

Lower value suggests faster cash conversion.

Asset Turnover Ratio

Measures how efficiently a company utilizes assets to generate sales.

Asset Turnover Ratio=Net SalesAverage Total Assets\text{Asset Turnover Ratio} = \frac{\text{Net Sales}}{\text{Average Total Assets}}

Higher ratio indicates better operational efficiency and productivity.

Payable Turnover Ratio

Assesses how efficiently a company manages trade payables.

Payable Turnover Ratio=Net Credit PurchasesAverage Accounts Payable\text{Payable Turnover Ratio} = \frac{\text{Net Credit Purchases}}{\text{Average Accounts Payable}}

Higher ratio suggests prompt supplier payment and effective cash management.

Days Payable Outstanding

Average number of days to pay suppliers, also called creditor days.

Days Payable Outstanding=365Payable Turnover Ratio\text{Days Payable Outstanding} = \frac{365}{\text{Payable Turnover Ratio}}

Higher value preserves cash but may strain supplier relationships. Lower value indicates prompter supplier payment.

Cash Conversion Cycle

Time taken to convert investments in inventory and other resources into cash from sales.

Cash Conversion Cycle=Days Sales of Inventory+Days Sales Outstanding−Days Payable Outstanding\text{Cash Conversion Cycle} = \text{Days Sales of Inventory} + \text{Days Sales Outstanding} - \text{Days Payable Outstanding}

Lower cycle indicates faster conversion and more efficient working capital management.

Profitability Ratios

Measure a company’s ability to generate profit relative to sales, assets, equity, and other factors.

Gross Profit Margin

Percentage of sales revenue remaining after deducting cost of goods sold.

Gross Profit Margin=Gross ProfitRevenue×100\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100

Higher margin indicates more profit from core operations.

Operating Profit Margin

Percentage of operating income relative to revenue.

Operating Profit Margin=Operating IncomeRevenue×100\text{Operating Profit Margin} = \frac{\text{Operating Income}}{\text{Revenue}} \times 100

Higher margin indicates more profit from core business activities, excluding non-operating expenses.

Net Profit Margin

Percentage of net income relative to revenue.

Net Profit Margin=Net IncomeRevenue×100\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times 100

Higher margin indicates more profit after all expenses, including taxes and interest.

Return on Assets

Percentage of net income relative to average total assets.

Return on Assets=Net IncomeAverage Total Assets×100\text{Return on Assets} = \frac{\text{Net Income}}{\text{Average Total Assets}} \times 100

Higher value indicates more profit per dollar of assets employed.

Return on Equity

Percentage of net income relative to average shareholders’ equity.

Return on Equity=Net IncomeAverage Shareholders’ Equity×100\text{Return on Equity} = \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} \times 100

Higher value indicates more profit per dollar of shareholders’ equity invested.

Investor and Market Value Ratios

Also known as market valuation ratios. Assess the relationship between a company’s stock price and its earnings, book value, or other financial metrics.

Earnings per Share

Portion of a company’s profit allocated to each outstanding share of common stock.

Earnings per Share=Net Income−Preferred DividendsWeighted Average Shares Outstanding\text{Earnings per Share} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}

Higher EPS may indicate higher earnings potential and attractiveness to investors.

Price-to-Earnings Ratio

Compares a company’s stock price to its earnings per share.

Price-to-Earnings Ratio=Market Price per ShareEarnings per Share\text{Price-to-Earnings Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share}}

Higher ratio suggests higher investor confidence and expectations of future growth.

Price-to-Book Ratio

Compares a company’s stock price to its book value per share.

Price-to-Book Ratio=Market Price per ShareBook Value per Share\text{Price-to-Book Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}

Higher ratio suggests investors are willing to pay a premium for the company’s book value.

Dividend Yield

Annual dividend income generated by a stock relative to its market price.

Dividend Yield=Annual Dividend per ShareMarket Price per Share×100\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Market Price per Share}} \times 100

Higher yield may be attractive to income-seeking investors.

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