Two companies report identical net income. One trades at twice the price-to-book of the other. Ratio analysis tells you why, and tells you which one is sustainable.
A raw number such as $25 million of net income says little on its own. Divide it by revenue, assets or equity and it becomes comparable across years and across companies. That is the core of ratio analysis. You calculate ratios in four families: activity ratios (how hard the assets work), liquidity ratios (can the firm pay bills due within a year), solvency ratios (can it carry its debt over the long run), and profitability ratios (how much it earns on sales and on capital).
Five tools and techniques dominate financial analysis. Ratio analysis scales one line item against another. Common-size analysis comes in two forms, and you should keep them apart.
- Vertical common-size analysis expresses each line as a percent of one base in the same period: revenue for the income statement, total assets for the balance sheet.
- Horizontal common-size analysis expresses each line as a percent of its own value in a base year, so you see how each item grew over time.
Common mistakes
- Treating a higher current ratio as automatically better. A 3.0 current ratio may signal idle cash or obsolete inventory. Trap: ranking Harbor (1.88) ahead of its peer (1.4) on current ratio alone.
- Mixing up turnover and days. Inventory turnover of 5 means DOH = 365/5 = 73 days, not 5 days. Trap: a question gives turnover and asks for days, or vice versa.
- Using COGS instead of purchases for payables. Harbor's payables turnover is $370M / $45M = 8.22, so DPO is 44.39 days. Dividing COGS by payables gives 7.78 and a trap DPO of 46.93 days.
Bottom line
- Four ratio families: activity (efficiency), liquidity (short-term coverage), solvency (long-term debt capacity), profitability (return generation)
- Flow over stock uses average balances; liquidity and debt ratios use year-end balances. Purchases = COGS + ending inventory − beginning inventory
- Cash Conversion Cycle = DOH + DSO − DPO. Lower is better; a negative value means suppliers finance operations
- Liquidity ladder: quick ratio strips inventory, cash ratio strips receivables too (the most stringent test)
Exam shortcut
For DuPont, remember "Margin × Turnover × Leverage." Margin comes from the income statement, leverage from the balance sheet, and turnover is the bridge because it divides an income statement number (revenue) by a balance sheet number (assets). For ratio family identification, classify by purpose. Margins and returns (including ROE) are profitability. Turnovers and their days versions (DOH, DSO, DPO) are activity.
The full lesson (about 4,334 words, 29 min read) adds 9 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- financial analysis techniques
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