Financial Analysis · Lesson 8
Ratio Analysis
for Investors
Big Idea
Ratios turn raw numbers into signals you can compare — across years, across companies, across industries. You do not need fifty of them. A focused toolkit of five families answers most questions:
- Liquidity — can the company meet short-term obligations?
- Profitability — does the business earn enough from operations?
- Leverage — how much debt supports the business?
- Efficiency — how well are receivables and inventory managed?
- Valuation — what is the market asking you to pay for it?
Ratios are conversation starters, not verdicts.
Liquidity and Profitability
| Ratio | Formula | What it suggests |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Short-term cushion |
| Quick ratio | (Cash + receivables) ÷ current liabilities | Liquidity without counting inventory |
| Gross margin | Gross profit ÷ revenue | Does pricing cover direct costs? |
| Net margin | Net income ÷ revenue | What survives to the bottom line |
| Return on equity | Net income ÷ equity | What the owners’ capital earns |
Caution on the current ratio: a strong number can still hide old receivables or slow-moving inventory. And a spectacular return on equity can simply mean the equity base is tiny because debt does all the work — always read ROE next to leverage.
Leverage and Efficiency
| Ratio | Formula | What it suggests |
|---|---|---|
| Debt-to-equity | Total liabilities ÷ equity | Reliance on debt vs owners’ capital |
| Interest coverage | Operating profit ÷ interest expense | How comfortably earnings pay the interest bill |
| Receivable days | Receivables ÷ revenue × 365 | How long customers take to pay |
| Inventory turnover | Cost of goods sold ÷ average inventory | How quickly stock moves |
Interest coverage is the equity investor’s early-warning gauge: coverage of 8× means earnings could fall by seven-eighths before the interest bill is threatened; coverage of 1.5× means one bad year puts the company in its lenders’ hands. And if receivable days stretch while inventory turnover slows, growth is consuming cash — the same trapdoor from Lesson 4, now in ratio form.
Valuation: What Are You Paying?
Everything so far judges the business. Valuation ratios judge the price:
| Ratio | Formula | What it asks |
|---|---|---|
| Price-to-earnings (P/E) | Share price ÷ earnings per share | How many years of today’s earnings am I paying up front? |
| EV / EBITDA | (Market value of equity + net debt) ÷ EBITDA | Price of the whole business, debt included — common in private deals |
| Price-to-book | Share price ÷ book value per share | Premium or discount to the accounting value of equity |
The two halves complete each other. A wonderful business at 60× earnings can be a poor investment; a mediocre business at 4× can be a bargain. Analysis without valuation buys quality at any price; valuation without analysis buys cheapness of any quality.
Worked Example
Selected figures: current assets $300,000; current liabilities $250,000; total liabilities $900,000; equity $300,000; operating profit $110,000; interest expense $40,000.
| Ratio | Calculation | Result |
|---|---|---|
| Current ratio | $300,000 ÷ $250,000 | 1.20 |
| Debt-to-equity | $900,000 ÷ $300,000 | 3.00 |
| Interest coverage | $110,000 ÷ $40,000 | 2.75× |
Translated: a thin but positive short-term cushion; three dollars of other people’s money for each dollar of the owners’; and earnings covering the interest bill under three times over. Not un-investable — but fragile, and priced accordingly or not at all.
Want to run these on a real company? Use the Financial Ratio Calculator — enter the statement figures and it computes the full toolkit with plain-English readings.
Interactive Checks
Check 1 of 3
Current assets are $500,000 (including $200,000 of inventory); current liabilities are $400,000.
What are the current ratio and quick ratio?
Check 2 of 3
Company A: ROE 25%, debt-to-equity 4.0. Company B: ROE 18%, debt-to-equity 0.5.
Why might a careful investor prefer Company B?
Check 3 of 3
Two similar companies: one trades at a P/E of 12, the other at 30.
What does the difference actually tell you?
Common Beginner Mistakes
- ❌ Treating ratios as verdicts. A ratio starts the conversation; the notes and context finish it.
- ❌ Comparing across industries. A grocer’s margins and a software company’s margins live on different planets.
- ❌ Admiring ROE without checking leverage. Debt can manufacture a beautiful ROE right up until it destroys the equity.
- ❌ Confusing a cheap multiple with a cheap company. Sometimes a P/E of 5 is a bargain; sometimes it is the market correctly pricing decline.
Key Takeaways
- Five families: liquidity, profitability, leverage, efficiency, valuation
- Interest coverage is the equity holder’s early-warning gauge
- Read ROE and leverage together — debt manufactures returns
- Business ratios judge quality; valuation ratios judge price — you need both
- Compare within the industry and the company’s own history
Next Lesson
Testing Management’s Story — projections, guidance, sensitivity analysis, and the red flags that mean “dig deeper before you invest.”