Financial Statement Analysis: Ratios

Overview

• What you’ll learn: The four categories of financial ratios (liquidity, profitability, solvency, efficiency), how to calculate and interpret each, and what the ratios reveal about a company’s health.
• Prerequisites: Lesson 4 — The Statement of Equity
• Estimated reading time: 18 minutes

Introduction

The Grand Historian records: Financial statements are rich with data, but data without analysis is merely noise. A revenue figure of $50 million is meaningless until you compare it to last year, to the industry average, or to the assets employed to generate it. Ratios are the alchemist’s tools — they transform raw numbers into gold: insights about profitability, liquidity, solvency, and operational efficiency.

No single ratio tells the whole story. An investor who relies on one ratio alone is like a physician who diagnoses based on pulse alone. The art lies in reading the ratios together, across time, and against competitors.

Liquidity Ratios

Measure the company’s ability to meet short-term obligations.

Example

Current Assets = $108,000; Current Liabilities = $31,000

Current Ratio = $108,000 / $31,000 = 3.48 (very strong liquidity)

Profitability Ratios

Measure the company’s ability to generate profit relative to revenue, assets, or equity.

Example

Net Income = $37,100; Net Sales = $200,000; Avg Total Assets = $220,000; Avg Equity = $130,000

• Net Profit Margin = $37,100 / $200,000 = 18.6%
• ROA = $37,100 / $220,000 = 16.9%
• ROE = $37,100 / $130,000 = 28.5%

Solvency (Leverage) Ratios

Measure the company’s ability to meet long-term obligations and the degree of financial leverage.

Efficiency (Activity) Ratios

Measure how effectively the company uses its assets.

The DuPont Analysis

The DuPont framework decomposes ROE into three components:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

This reveals why ROE is high or low — is it because of strong margins, efficient asset use, or high leverage?

Key Takeaways

• Ratios fall into four categories: liquidity, profitability, solvency, and efficiency.
• No single ratio tells the whole story — analyze them together, over time, and against peers.
• Liquidity ratios assess short-term solvency; leverage ratios assess long-term solvency.
• ROE is the ultimate profitability measure; DuPont analysis decomposes it into margin, turnover, and leverage.
• Context matters — a 2.0 current ratio may be healthy in one industry and excessive in another.

What’s Next

In Lesson 6, you will learn Horizontal and Vertical Analysis — trend analysis and common-size statements that reveal patterns hidden in the raw numbers.