A ratio means little alone. Compare it with the company's own history and with direct peers.
| Group | Ratio | Formula | Maple Outfitters |
|---|---|---|---|
| Liquidity | Current ratio | Current assets / current liabilities | 350 / 90 = 3.89 |
| Liquidity | Quick ratio | (Cash + receivables) / current liabilities | 200 / 90 = 2.22 |
| Solvency | Debt to equity | Total debt / equity | 300 / 460 = 0.65 |
| Solvency | Net debt to EBITDA | (Debt minus cash) / EBITDA | 220 / 180 = 1.22 |
| Solvency | Interest coverage | EBIT / interest expense | 130 / 20 = 6.5 |
| Profitability | Gross margin | Gross profit / revenue | 40.0% |
| Profitability | Operating margin | EBIT / revenue | 13.0% |
| Profitability | Net margin | Net income / revenue | 8.25% |
| Profitability | Return on assets (ROA) | Net income / total assets | 9.7% |
| Profitability | Return on equity (ROE) | Net income / equity | 17.9% |
| Profitability | Return on invested capital (ROIC) | EBIT x (1 minus tax rate) / (debt + equity) | 97.5 / 760 = 12.8% |
| Efficiency | Asset turnover | Revenue / total assets | 1.18 |
| Efficiency | Days sales outstanding | Receivables / revenue x 365 | 43.8 days |
| Efficiency | Days inventory outstanding | Inventory / COGS x 365 | 91.3 days |
| Efficiency | Days payables outstanding | Payables / COGS x 365 | 54.8 days |
Textbooks often use average balances for the denominator of return and turnover ratios. Year-end balances are used here for simplicity; be consistent.
Cash conversion cycle (CCC) = DSO + DIO minus DPO = 43.8 + 91.3 minus 54.8 = 80.3 days. This is how long cash is tied up between paying suppliers and collecting from customers. A shorter cycle needs less financing. Some retailers and subscription firms have negative cycles: customers pay before suppliers are paid.
ROE splits into three drivers:
Maple: 8.25% x 1.176 x 1.848 = 17.9%. Two companies with the same ROE can be very different: a grocer earns it with thin margins and high turnover, a luxury brand with fat margins, a bank with leverage. ROE driven mainly by leverage is riskier.
A company creates value only when ROIC exceeds its cost of capital (covered in RS 202). Growth at an ROIC below the cost of capital destroys value.
Different accounting policies, different fiscal year ends, seasonality in balance sheet dates, acquisitions and one-time items all distort ratios. Always read the notes before trusting a comparison.
The three-step version can be split further to separate operations from financing and tax:
The five terms are the tax burden, the interest burden, the EBIT margin, asset turnover and financial leverage. Maple: 0.750 x 0.846 x 0.130 x 1.176 x 1.848 = 17.9%. The split shows that Maple's interest costs take about 15% of its operating profit and tax a quarter of the rest.
| Measure | Firm A | Firm B |
|---|---|---|
| Revenue | 500 | 500 |
| Net income | 50 | 25 |
| Total assets | 400 | 250 |
| Equity | 300 | 100 |
| Net margin | 10.0% | 5.0% |
| Asset turnover | 1.25 | 2.00 |
| Leverage (assets / equity) | 1.33 | 2.50 |
| ROE | 16.7% | 25.0% |
Firm B has the higher ROE, but half of it comes from leverage. If B's margin fell to 2%, its ROE would drop to 10%; with liabilities of 150 against equity of 100, it has much less room for error than A.
Return and turnover ratios mix a flow (a year of profit or revenue) with a stock (a balance on one date). Using the average of opening and closing balances matches them better. With opening equity of 440, closing equity of 480 and net income of 92, ROE on average equity is 92 / 460 = 20.0%, against 19.2% on closing equity.
Accrual ratios can be flattered; cash ratios are harder to fake. Useful ones: operating cash flow / current liabilities (liquidity), free cash flow / total debt (how fast debt could be repaid), and cash conversion (CFO / net income). Maple's FCF / debt is 22.5 / 300 = 7.5%: about 13 years to repay its debt from free cash flow alone.
For public manufacturers:
Z = 1.2 x (working capital / total assets) + 1.4 x (retained earnings / total assets) + 3.3 x (EBIT / total assets) + 0.6 x (market value of equity / total liabilities) + 1.0 x (revenue / total assets)
Assume retained earnings of 300 and a share price of $10 (market value of equity 1,000). Total liabilities are 90 + 300 = 390.
Z is about 4.1, well inside the safe zone above 3.0.
Ratios only mean something against the right peer group. A grocer earns net margins of 2% to 3% and turns its assets over several times a year; a software company can have gross margins above 70% and almost no inventory; a utility carries high debt against stable regulated cash flow. Compare like with like.
Build a ratio sheet with all 15 ratios for two competitors over three years. Write five sentences on which is the stronger business and why.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.