Ch10. Financial Ratio Analysis — Diagnosing a Company's Health Through Numbers

What Is Financial Ratio Analysis?

Financial Ratio Analysis: A method of evaluating a company’s financial condition and operating performance by calculating ratios between items in the financial statements.

Comparison Benchmarks:

Time-Series Analysis: Same company’s past vs. present performance
Cross-Sectional Analysis: Comparison with competitors in the same industry
Industry Averages: Comparison against published industry benchmarks

Profitability Ratios

Measure how efficiently a company generates profit.

Gross Profit Margin    = Gross Profit / Revenue × 100%
Operating Profit Margin = Operating Income / Revenue × 100%
Net Profit Margin      = Net Income / Revenue × 100%
ROA                    = Net Income / Average Total Assets × 100%
ROE                    = Net Income / Average Shareholders' Equity × 100%
ROIC                   = NOPAT / Invested Capital × 100%

ROE vs. ROA: ROE is from the shareholder’s perspective; ROA measures total asset utilization efficiency. High leverage means ROE > ROA.

Liquidity Ratios

Measure the ability to meet short-term obligations.

Current Ratio    = Current Assets / Current Liabilities × 100%  (2:1 or 200% recommended)
Quick Ratio      = (Current Assets − Inventory) / Current Liabilities × 100%  (1:1 or 100%+)
Cash Ratio       = (Cash + Cash Equivalents) / Current Liabilities × 100%

Solvency / Leverage Ratios

Measure long-term debt repayment ability and overall financial health.

Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity × 100%  (lower = more stable)
Equity Ratio         = Shareholders' Equity / Total Assets × 100%  (higher = more stable)
Interest Coverage    = Operating Income / Interest Expense  (below 1 = danger)

Interest Coverage < 1: Operating income is insufficient to cover interest payments → financial distress signal

Activity / Efficiency Ratios

Measure how efficiently assets are being utilized.

Asset Turnover            = Revenue / Average Total Assets  (higher = more efficient)
Inventory Turnover        = COGS / Average Inventory
Accounts Receivable Turnover = Revenue / Average Accounts Receivable
Days Sales Outstanding (DSO) = 365 / Accounts Receivable Turnover  (days)

Growth Ratios

Revenue Growth Rate        = (Current Revenue − Prior Revenue) / Prior Revenue × 100%
Operating Income Growth Rate
Total Asset Growth Rate
EPS Growth Rate            = (Current EPS − Prior EPS) / Prior EPS × 100%

Stock Valuation Metrics

Metric	Formula	Meaning
P/E Ratio	Stock Price / EPS	How many times earnings investors are paying
P/B Ratio	Stock Price / Book Value Per Share	Stock price relative to net asset value
EPS	Net Income / Shares Outstanding	Earnings per share
Book Value Per Share (BPS)	Net Assets / Shares Outstanding	Net assets per share
Dividend Yield	Dividends Per Share / Stock Price × 100%	Return from dividends on investment

DuPont Analysis

A framework that decomposes ROE into three components to identify what is driving the result.

ROE = Net Profit Margin × Asset Turnover × Financial Leverage

ROE = (Net Income / Revenue) × (Revenue / Total Assets) × (Total Assets / Equity)
    =   Profitability       ×      Efficiency          ×      Leverage

How to use it: When ROE is high, determine whether it comes from improved profit margins, better asset utilization, or greater use of debt (leverage).

Interest Coverage Ratio ★★★★★ : Operating Income ÷ Interest Expense. Below 1 means operating income cannot cover interest payments — a sign of financial distress. Memory tip: Coverage of 1 = just barely covering interest; below 1 = danger

DuPont Analysis ★★★★★ : ROE = Net Profit Margin × Asset Turnover × Financial Leverage. Decomposes the drivers of ROE change into three factors. Memory tip: Profitability × Efficiency × Leverage

P/B Ratio ★★★★☆ : Stock Price ÷ Book Value Per Share. Below 1 means the stock trades below net asset value (potentially undervalued). Memory tip: P/B of 1 = trading at exact net asset value

Practice Quiz

Q. Compare a company with a current ratio of 300% versus one with 80%.

300% means ample short-term liquidity. 80% means current assets are less than current liabilities — potential difficulty meeting short-term obligations. However, an excessively high current ratio may also indicate inefficient use of assets.

Q. Two companies have the same ROE but different DuPont analysis results. What does this mean?

The same ROE can stem from very different sources: high profit margins, superior asset efficiency (high turnover), or heavy use of leverage (debt). ROE driven primarily by high leverage carries more financial risk than ROE driven by genuine profitability or efficiency.