Ratio Analysis

Raw numbers can be hard to interpret. A profit of 5 million might be excellent for a small company and poor for a large one. Ratios put figures into context by comparing them with each other, such as profit with revenue, or debt with equity.

Ratios are usually grouped into families. Profitability ratios, such as operating margin and return on equity, show how well a company turns sales and capital into profit. Liquidity ratios, such as the current ratio, show whether it can meet short-term bills. Efficiency ratios, such as asset turnover and days sales outstanding, show how well it uses its resources. Leverage ratios, such as debt-to-equity, show how much it relies on borrowing. Valuation ratios, such as price-to-earnings, relate market value to financial results.

For example, a company with revenue of 2 million and operating income of 300,000 has an operating margin of 15%, which can be compared with competitors or with its own past results.

Ratios are most useful when compared over time or against similar companies. A single ratio on its own rarely tells the full story, and differences in accounting policies or business models can make comparisons misleading if not considered.