Ratios

Section: Financial Ratio Analysis Estimated study time: 45 minutes Content: Financial ratio analysis is the primary quantitative tool for evaluating company performance, financial health, and valuation. Ratios are most useful when compared across time (trend analysis) and against industry peers (cross-sectional analysis), since absolute numbers in isolation rarely tell a complete story. The DuPont analysis framework decomposes return on equity (ROE) into its component drivers: ROE = Net Profit Margin × Asset Turnover × Financial Leverage (Equity Multiplier). In its extended form: ROE = (Net Income / EBT) × (EBT / EBIT) × (EBIT / Revenue) × (Revenue / Assets) × (Assets / Equity). This decomposition reveals whether ROE is driven by strong margins, efficient asset use, or high leverage — critical for understanding the sustainability and quality of profitability. Liquidity ratios measure a company's ability to meet short-term obligations. The current ratio = Current Assets / Current Liabilities; a ratio below 1.0 signals potential liquidity stress. The quick ratio (acid test) = (Cash + Short-term investments + Receivables) / Current Liabilities; this excludes inventory (which may not be quickly liquidable) and is a more conservative liquidity measure. The cash ratio = (Cash + Short-term investments) / Current Liabilities is the most stringent. The cash conversion cycle (CCC) = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO) measures how many days it takes to convert inventory investment into cash; a shorter CCC is more favorable. High CCC relative to peers can indicate working capital inefficiency or aggressive revenue recognition. Solvency ratios evaluate long-term financial stability and the company's ability to service debt. The debt-to-equity ratio = Total Debt / Total Equity; higher values…