Ratios make statements comparable. They strip out scale (a $10B company vs a $100M company), strip out currency, and surface relationships that raw numbers hide. There are dozens; you'll use about a dozen routinely.
Profitability ratios
- Gross margin = Gross profit ÷ Revenue — pricing power
- Operating margin = Operating income ÷ Revenue — operating leverage and cost discipline
- Net margin = Net income ÷ Revenue — bottom-line efficiency
- Return on equity (ROE) = Net income ÷ Average equity — return generated on shareholder capital
- Return on assets (ROA) = Net income ÷ Average assets — return generated on the asset base
- Return on invested capital (ROIC) = NOPAT ÷ Invested capital — the cleanest measure of capital allocation skill
Liquidity ratios
- Current ratio = Current assets ÷ Current liabilities — can short-term obligations be met? Want > 1.0
- Quick ratio = (Current assets − Inventory) ÷ Current liabilities — same, but stricter (inventory may not convert quickly)
Leverage ratios
- Debt-to-equity = Total debt ÷ Equity — capital structure
- Debt-to-EBITDA = Total debt ÷ EBITDA — how many years of operating cash flow it would take to repay debt; <3x is generally healthy
- Interest coverage = EBIT ÷ Interest expense — ability to service debt; >5x is comfortable, <2x is precarious
Efficiency ratios
- Asset turnover = Revenue ÷ Average assets — how much revenue each dollar of assets generates
- Inventory turnover = COGS ÷ Average inventory — how many times inventory is sold per year
DuPont decomposition — the most useful identity in ratio analysis
ROE = Net margin × Asset turnover × Equity multiplier
Three ways to drive return on equity: be more profitable per dollar of revenue, generate more revenue per dollar of assets, or use more debt. Two companies with the same ROE can have radically different drivers — and radically different risk profiles.
Three ratios to ignore
- P/E ratio in isolation — meaningless without growth context
- Book value when assets are mostly intangible — a software company's BV is largely meaningless
- Dividend yield without payout ratio — a 10% yield from a 200% payout ratio is a dividend cut waiting to happen
Exercise
Decompose ROE for two companies. Co A: Net margin 5%, Asset turnover 2.0x, Equity multiplier 1.5. Co B: Net margin 20%, Asset turnover 0.5x, Equity multiplier 1.5. Compute ROE for both and comment.