Skip to content

Ratio Analysis

Difficulty intermediate

Overview

Ratio analysis transforms raw financial data into comparable metrics that reveal a company's profitability, efficiency, liquidity, and valuation relative to peers and history.

Profitability Ratios

Return on Equity (ROE)

ROE = Net Income / Shareholders' Equity

Measures: How effectively a company uses shareholder capital
Good: > 15% for most industries
Decompose with DuPont Analysis

where: Net Income GAAP after-tax profit · Shareholders' Equity book value of common equity does: the headline return on owner-supplied capital — used to rank capital allocators and spot leverage-juiced returns when decomposed via DuPont; high without rising debt signals genuine compounders.

Return on Assets (ROA)

ROA = Net Income / Total Assets

Measures: How efficiently assets generate profit
Good: > 5% (varies by industry)

where: Net Income after-tax profit · Total Assets book value of all firm assets does: the return per dollar of balance-sheet assets, independent of how those assets are financed — used to compare operating efficiency across firms with different leverage and especially for asset-heavy businesses.

Return on Invested Capital (ROIC)

ROIC = NOPAT / Invested Capital

NOPAT = EBIT × (1 - Tax Rate)
Invested Capital = Total Debt + Equity - Cash

Measures: Return on all capital (debt + equity)
Good: > WACC (indicates value creation)

where: NOPAT net operating profit after tax · EBIT earnings before interest and taxes · Invested Capital debt plus equity minus excess cash · WACC weighted average cost of capital does: the cleanest capital-structure-neutral measure of operating return — used to test whether a business is creating economic value (ROIC > WACC) and to compare reinvestment quality across firms regardless of leverage.

Liquidity Ratios

Ratio Formula Good Range Warning
Current Ratio Current Assets / Current Liabilities 1.5-3.0 < 1.0
Quick Ratio (CA - Inventory) / Current Liabilities > 1.0 < 0.8
Cash Ratio Cash / Current Liabilities > 0.2 < 0.1
Operating Cash Flow Ratio OCF / Current Liabilities > 0.4 < 0.2

Leverage Ratios

Ratio Formula Good Range Warning
Debt/Equity Total Debt / Total Equity < 1.5 > 3.0
Debt/EBITDA Total Debt / EBITDA < 3.0 > 5.0
Interest Coverage EBIT / Interest Expense > 3.0 < 1.5
Debt/Assets Total Debt / Total Assets < 0.5 > 0.7
Equity Multiplier Total Assets / Total Equity < 3.0 > 5.0

Efficiency Ratios

Ratio Formula Interpretation
Asset Turnover Revenue / Total Assets Higher = more efficient
Inventory Turnover COGS / Average Inventory Higher = faster sales
Receivables Turnover Revenue / Average AR Higher = faster collection
Payables Turnover COGS / Average AP Higher = faster payment
Cash Conversion Cycle DIO + DSO - DPO Lower = better

Valuation Ratios

Ratio Formula Use Case
P/E Price / EPS Profitable companies
Forward P/E Price / Forward EPS Growth expectations
PEG P/E / EPS Growth Rate Growth-adjusted valuation
EV/EBITDA Enterprise Value / EBITDA Cross-company comparison
P/S Price / Revenue Unprofitable companies
P/B Price / Book Value Asset-heavy, financials
EV/Sales Enterprise Value / Sales SaaS, high-growth
FCF Yield Free Cash Flow / Market Cap Cash generation
Dividend Yield Annual Dividend / Price Income stocks
P/FCF Price / Free Cash Flow Cash-based valuation

Practical Guidelines

  1. Context Matters — Ratios vary significantly by industry
  2. Trend Over Single Point — 5-year trends tell more than one year
  3. Cross-Reference — Don't rely on a single ratio
  4. Cash Over Earnings — Cash flow ratios are harder to manipulate
  5. Quality of Earnings — Check for one-time items and adjustments
  6. Compare to Peers — Absolute numbers mean little without context
  7. Look at the Notes — Footnotes reveal important details

Next Steps