This guide works through a ratio analysis of Example Co., an illustrative company that is not a real business. Its figures are made up to show the method, and they are the same illustrative figures the site’s Financial Statement Map uses. Every ratio below was calculated with the formula engine that runs the calculators on this site.
The figures cover a single year, and there are no figures for earlier years or for similar businesses. That limits what the analysis can conclude, and the last section sets out what you would need to go further.
The figures
Balance sheet at year end
| Line item | Amount |
|---|---|
| Cash and cash equivalents | 40,000 |
| Short-term investments | 20,000 |
| Accounts receivable | 60,000 |
| Inventory | 80,000 |
| Current assets | 200,000 |
| Total assets | 500,000 |
| Accounts payable | 50,000 |
| Current liabilities | 100,000 |
| Total debt (interest-bearing) | 150,000 |
| Total liabilities | 250,000 |
| Shareholders’ equity | 250,000 |
Income statement for the year
| Line item | Amount |
|---|---|
| Revenue | 600,000 |
| Cost of goods sold | 360,000 |
| Gross profit | 240,000 |
| Operating income | 90,000 |
| Interest expense | 10,000 |
| Income tax expense | 20,000 |
| Net income | 60,000 |
| Depreciation | 25,000 |
| Amortization | 5,000 |
| EBITDA | 120,000 |
Two details matter later. Current assets consist only of cash, short-term investments, receivables and inventory, with no prepaid expenses. Current liabilities include 50,000 of accounts payable, but the statements do not say what the other 50,000 is, or how much of the 150,000 of debt falls due within the year.
Current ratio = Current assets ÷ Current liabilities
200,000 ÷ 100,000 = 2.00
How the current ratio worksOf $600,000 of revenue, $360,000 goes on the cost of goods sold, leaving gross profit of $240,000. Operating expenses of $150,000 leave operating income of $90,000, and after interest and tax, net income is $60,000: 10 cents of every revenue dollar. Illustrative company, not actual results.
How the ratios were calculated
On this site, return on assets, return on equity, the equity multiplier, asset turnover, inventory turnover and the day counts use the average of the opening and closing balances when both are available. Example Co. has only year-end balances, so every ratio here uses year-end balances. The site’s calculators do the same when no opening balance is entered, and say so in the result. If the balance sheet grew or shrank during the year, averages would give different answers; the guide to average vs ending balances explains why. Day counts use a 365-day year.
Results
| Ratio | Calculation | Result |
|---|---|---|
| Current ratio | 200,000 ÷ 100,000 | 2.00 |
| Quick ratio | (40,000 + 20,000 + 60,000) ÷ 100,000 | 1.20 |
| Cash ratio | 40,000 ÷ 100,000 | 0.40 |
| Working capital | 200,000 − 100,000 | 100,000 |
| Gross profit margin | 240,000 ÷ 600,000 | 40.0% |
| Operating profit margin | 90,000 ÷ 600,000 | 15.0% |
| Net profit margin | 60,000 ÷ 600,000 | 10.0% |
| EBITDA margin | 120,000 ÷ 600,000 | 20.0% |
| Return on assets | 60,000 ÷ 500,000 | 12.0% |
| Return on equity | 60,000 ÷ 250,000 | 24.0% |
| Equity multiplier | 500,000 ÷ 250,000 | 2.00 |
| Debt-to-equity (total liabilities) | 250,000 ÷ 250,000 | 1.00 |
| Debt-to-equity (interest-bearing debt) | 150,000 ÷ 250,000 | 0.60 |
| Debt-to-assets | 250,000 ÷ 500,000 | 50.0% |
| Interest coverage | 90,000 ÷ 10,000 | 9.00 |
| Asset turnover | 600,000 ÷ 500,000 | 1.20 |
| Inventory turnover | 360,000 ÷ 80,000 | 4.50 |
| Days inventory outstanding | 80,000 ÷ 360,000 × 365 | 81.1 days |
| Days payable outstanding | 50,000 ÷ 360,000 × 365 | 50.7 days |
Liquidity
The current ratio of 2.00 means current assets were twice current liabilities at year end, and working capital was 100,000. The quick ratio leaves out inventory, so the step down from 2.00 to 1.20 is the 80,000 of inventory. Because Example Co. has no prepaid expenses, the other common version of the quick ratio, current assets minus inventory, also gives 1.20.
The cash ratio of 0.40 counts only cash and cash equivalents, so the 20,000 of short-term investments are left out. Read together, the three ratios show that current assets exceeded current liabilities, but that cash alone covered 0.40 of them. The rest of the cover depends on selling the investments, collecting receivables and selling inventory.
Profitability
The margins trace revenue down the income statement. Gross profit margin is 40.0%, after the 360,000 cost of goods sold. Operating profit margin is 15.0%, so operating expenses took another 25 percentage points. Interest and tax bring net profit margin down to 10.0%.
The EBITDA margin of 20.0% is 5 points above the operating margin because EBITDA adds back the 30,000 of depreciation and amortization. The engine gives the same EBITDA of 120,000 whether it starts from net income or from operating income, and building EBIT up from net income gives 90,000, equal to operating income. So, apart from interest, Example Co.’s figures include no non-operating income or expenses, and the usual definition choices for EBIT and EBITDA make no difference here.
Returns and the DuPont breakdown
Return on assets is 12.0% and return on equity is 24.0%. A DuPont analysis shows where the difference comes from: net profit margin of 10.0% × asset turnover of 1.20 × equity multiplier of 2.00 = return on equity of 24.0%.
Net profit margin 10.0% × Asset turnover 1.20 × Equity multiplier 2.00 = return on equity 24.0%.
Margin and turnover together give the 12.0% return on assets. The equity multiplier of 2.00 means liabilities finance half of the assets, which doubles the return measured on equity. On these figures, 12 of the 24 percentage points of return on equity come from how Example Co. is financed rather than from what it earns on its assets.
Leverage and coverage
The debt-to-equity ratio is 1.00 on the site’s default definition, which counts all liabilities, including the 50,000 owed to suppliers. Counting only the 150,000 of interest-bearing debt gives 0.60. Both are correct calculations of different things, so say which one you use when you compare. The debt-to-assets ratio of 50.0% shows the same structure as the equity multiplier from another angle: liabilities finance half of total assets.
The interest coverage ratio of 9.00 means operating income covered the year’s interest expense nine times. It says nothing about repaying the debt itself. The debt service coverage ratio would add scheduled principal repayments, but the statements do not show them, so it cannot be calculated here.
Efficiency
Asset turnover of 1.20 means revenue was 1.20 times total assets. Inventory turnover of 4.50 means cost of goods sold was 4.5 times year-end inventory; put in days, year-end inventory equals about 81.1 days of cost of goods sold. Days payable outstanding of 50.7 days estimates how long Example Co. takes to pay its suppliers, measured against the same cost of goods sold.
On these year-end figures, inventory is held for longer than suppliers wait to be paid, so supplier credit finances only part of the time inventory is held. The full cash cycle would also need days sales outstanding, which uses credit sales. The statements show only total revenue, and using it instead would understate DSO if some customers pay in cash, so this example leaves DSO and the cash conversion cycle out.
What the ratios show together
Read as a set, and for this one year only, the ratios describe a business that:
- made a profit at every level of the income statement, with net income of 10.0% of revenue;
- financed half of its assets with liabilities, which lifted return on equity to twice return on assets;
- earned operating income of nine times its interest expense;
- held current assets of twice its current liabilities, with more of that cover in receivables and inventory than in cash and short-term investments.
None of these points says whether Example Co. is doing well or badly. A gross margin of 40.0%, a debt-to-equity ratio of 1.00 or inventory turnover of 4.50 can be ordinary in one industry and unusual in another, and a single year cannot show whether any of them is improving or getting worse.
What you would need before drawing conclusions
- Earlier years. Several years of statements would show the trend in each ratio and allow average balances.
- Similar businesses. Ratios for comparable companies, calculated on the same definitions, would show which results are typical for the business model.
- The cash flow statement. Operating cash flow would show whether profit turned into cash, and the investing and financing sections would show capital spending, borrowing and repayments.
- The notes. Debt maturities and interest rates, what the other 50,000 of current liabilities is, how inventory is valued and whether any of it is slow-moving, and how long receivables have been outstanding.
- Sales and supplier terms. Credit sales for DSO, and the payment terms Example Co. gives customers and receives from suppliers, to set the day counts against.
- Timing and one-off items. Whether the year end falls in a quiet or busy season, and whether net income includes any unusual gains or costs.
- Market data. A share price and share count, if the shares trade, for valuation ratios such as price-to-earnings.
With that information, the method in how to analyze financial ratios can turn these single-year results into a fuller picture. The guide to the limitations of financial ratio analysis explains what even a complete set of ratios cannot tell you.