Financial ratio analysis: the ratios that matter, with formulas
The core financial ratios in four groups, each with its formula, computed for a two-year example company, plus the DuPont check and common mistakes.
A financial ratio divides one figure from the statements by another, so that the result can be compared across years and across companies. Most of the useful ratios fall into four groups: liquidity, profitability, efficiency and solvency. Each ratio needs a precise formula, and the period of the income figure has to match the period of the balance it is compared with. Both points matter more than the choice of ratio.
This article gives the formula for each core ratio, computes every one for a fictional company over two years, checks return on equity with the DuPont identity, and lists the mistakes that most often change the answer. All figures are in USD thousands and are illustrative. The financial ratio analysis template runs the same calculations, and a trial balance can be mapped to the statements first.
What are the four groups of financial ratios?
| Group | The question it answers | Ratios in this article |
|---|---|---|
| Liquidity | Can the company meet obligations due within a year? | Current ratio, quick ratio |
| Profitability | How much of each sale is kept, and how well is capital used? | Gross, operating and net margin, ROA, ROE |
| Efficiency | How quickly do sales and purchases move through the balance sheet? | Asset turnover, DSO, DIO, DPO, cash conversion cycle |
| Solvency | How much of the funding is debt, and does profit cover interest? | Debt-to-equity, interest coverage, equity multiplier |
Which financial statements does ratio analysis need?
The company has a balance sheet at three year-ends and an income statement for two years. The opening balance sheet, at the end of year 0, is needed for the averages.
| Balance sheet (USD thousands) | End of Y0 | End of Y1 | End of Y2 |
|---|---|---|---|
| Cash | 180 | 210 | 265 |
| Accounts receivable | 240 | 290 | 330 |
| Inventory | 310 | 360 | 395 |
| Other current assets | 30 | 35 | 40 |
| Current assets | 760 | 895 | 1,030 |
| PP&E, net | 1,020 | 1,080 | 1,130 |
| Total assets | 1,780 | 1,975 | 2,160 |
| Accounts payable | 190 | 215 | 240 |
| Accrued liabilities | 60 | 70 | 75 |
| Short-term debt | 80 | 90 | 100 |
| Current liabilities | 330 | 375 | 415 |
| Long-term debt | 520 | 560 | 600 |
| Equity | 930 | 1,040 | 1,145 |
| Income statement (USD thousands) | Y1 | Y2 |
|---|---|---|
| Revenue | 2,400 | 2,760 |
| Cost of goods sold | 1,560 | 1,800 |
| Gross profit | 840 | 960 |
| Operating expenses | 540 | 600 |
| Operating income (EBIT) | 300 | 360 |
| Interest expense | 36 | 40 |
| Income tax | 66 | 80 |
| Net income | 198 | 240 |
Each balance sheet balances: total assets equal current liabilities, long-term debt and equity. Equity rose by 110 in Y1 and 105 in Y2. Net income less that change gives the dividends implied by the equity roll-forward: 88 in Y1 and 135 in Y2.
Should ratios use averages or year-end balances?
An income figure covers a full year, but a balance sheet figure is a single point in time. Ratios that set the two against each other, such as ROE or DIO, should use the average of the opening and closing balances. The averages used here are:
| Average balance | Y1 | Y2 |
|---|---|---|
| Accounts receivable | 265.0 | 310.0 |
| Inventory | 335.0 | 377.5 |
| Accounts payable | 202.5 | 227.5 |
| Total assets | 1,877.5 | 2,067.5 |
| Equity | 985.0 | 1,092.5 |
The difference is not small. With year-end balances, Y1 ROE would be 19.04% instead of 20.10%, and DIO would be 84.2 days instead of 78.4. Year-end inventory in Y1 (360) was above the average for the year (335), so the year-end figure overstates the days of stock. Ratios that describe a position on one date, such as the current ratio and debt-to-equity, use year-end balances.
What are the formulas for the core financial ratios?
| Ratio | Formula | Y1 | Y2 |
|---|---|---|---|
| Current ratio | current assets / current liabilities |
2.39 | 2.48 |
| Quick ratio | (current assets - inventory) / current liabilities |
1.43 | 1.53 |
| Gross margin | gross profit / revenue |
35.00% | 34.78% |
| Operating margin | operating income / revenue |
12.50% | 13.04% |
| Net margin | net income / revenue |
8.25% | 8.70% |
| ROA | net income / average total assets |
10.55% | 11.61% |
| ROE | net income / average equity |
20.10% | 21.97% |
| Asset turnover | revenue / average total assets |
1.28 | 1.33 |
| DSO | average receivables / revenue * 365 |
40.3 days | 41.0 days |
| DIO | average inventory / cost of goods sold * 365 |
78.4 days | 76.5 days |
| DPO | average payables / cost of goods sold * 365 |
47.4 days | 46.1 days |
| Cash conversion cycle | DSO + DIO - DPO |
71.3 days | 71.4 days |
| Debt-to-equity | (short-term debt + long-term debt) / equity |
0.625 | 0.611 |
| Interest coverage | operating income / interest expense |
8.33 | 9.00 |
| Equity multiplier | average total assets / average equity |
1.91 | 1.89 |
Liquidity uses year-end balances. The quick ratio removes inventory because inventory takes longer to turn into cash than receivables do. Inventory is 40% of Y1 current assets (360 of 895), which is why the quick ratio sits well below the current ratio.
DIO and DPO use cost of goods sold, because inventory and payables are carried at cost. The cash conversion cycle combines the three days figures: receivables are collected after DSO days, inventory is held for DIO days, and suppliers are paid after DPO days. The days in Y2 changed little overall. DSO rose by 0.69 days, DIO fell by 1.83 days and DPO fell by 1.25 days, so the cycle moved from 71.30 to 71.41 days.
How does the DuPont check break ROE into three factors?
ROE can be broken into three factors: net margin (how much of each sale is kept), asset turnover (how many sales each dollar of assets produces) and the equity multiplier (how many dollars of assets each dollar of equity supports). Their product is ROE:
ROE = net margin × asset turnover × equity multiplier
The identity is exact when the same averages are used throughout, because the revenue and average asset terms cancel. The table checks it for both years:
| DuPont factor | Y1 | Y2 |
|---|---|---|
| Net margin | 8.2500% | 8.6957% |
| Asset turnover | 1.2783 | 1.3349 |
| Equity multiplier | 1.9061 | 1.8924 |
| Product (ROE) | 20.1015% | 21.9680% |
ROE rose by 1.87 percentage points. The net margin and asset turnover both rose, and the equity multiplier fell slightly, so the company earned more from each dollar of sales and each dollar of assets, and carried slightly less debt per dollar of equity. The breakdown shows which lever moved. A rise in ROE that came only from borrowing would show up as a higher equity multiplier with the other two factors flat.
How do you judge whether a ratio value is good?
No universal number counts as a good current ratio, a good margin or a good DSO. A company's own trend is the first comparison. Two years is a short series, and three to five years of statements show whether a change is a trend or a single year. The second comparison is with companies in the same industry and business model. A business that collects cash from customers before it pays suppliers can run a current ratio below 1 for long periods. A business with slow-moving stock needs more liquidity to carry it. Compare like with like, and explain any gap before drawing a conclusion.
What mistakes make financial ratios misleading?
- Mixing periods. Dividing a full-year income figure by a balance from a single quarter, or comparing a 12-month ratio with a quarter's, gives a result that means nothing. Match the period of the income to the period of the balance.
- Using revenue for DIO and DPO. Inventory and payables relate to cost of goods sold. On revenue, Y1 DIO reads 50.9 days instead of 78.4, and DPO reads 30.8 days instead of 47.4.
- Ignoring seasonality. A retailer's balances at year-end may sit after a holiday peak, so the year-end ratios describe the quietest point, not the typical one. Use monthly averages, or compare the same quarter in each year.
- Treating one ratio as the answer. A high ROE with a high equity multiplier and a thin margin is a different position from a high ROE built on margin. Read the groups together.
How do you set up the ratios in a spreadsheet?
Put the opening balance sheet in column B and the year-end figures in columns C (Y1) and D (Y2), with the balance sheet in rows 2 to 14 and the income statement in rows 18 to 25 in the order shown above. Then, in column C:
- Current ratio, C28:
=C6/C12 - Quick ratio, C29:
=(C6-C4)/C12 - Net margin, C32:
=C25/C18 - ROA, C33:
=C25/AVERAGE(B8,C8) - ROE, C34:
=C25/AVERAGE(B14,C14) - DSO, C36:
=AVERAGE(B3,C3)/C18*365 - DIO, C37:
=AVERAGE(B4,C4)/C19*365 - DPO, C38:
=AVERAGE(B9,C9)/C19*365 - Cash conversion cycle, C39:
=C36+C37-C38 - Debt-to-equity, C40:
=(C11+C13)/C14 - Interest coverage, C41:
=C22/C23 - Equity multiplier, C42:
=AVERAGE(B8,C8)/AVERAGE(B14,C14) - DuPont check, C43:
=C32*C35*C42, which returns the same value as C34
Fill the formulas across to column D and check that the DuPont row matches ROE. Cash in current assets should agree with the bank before any ratio is calculated, which is what the bank reconciliation checks. For the first ratio on its own, see what is the current ratio, and for the cash check, what is a bank reconciliation.