Two businesses can report very different financial ratios for reasons that have nothing to do with how well they are managed. A ratio compares two figures from the financial statements, and those figures depend on what the business does: what it sells, what it needs to own, how its customers pay and how it raises money.
Ratios follow the business model
A business that makes products in its own factories, one that resells goods it buys from others and one that sells professional time all prepare accounts under the same rules. Their statements still look very different, because they need different resources and earn money in different ways. The factors below are structural: they explain why a figure that is ordinary for one business model can be unusual for another, without saying anything about how well either business is run.
A network business ties most of its assets up in property and equipment, a retailer in inventory and stores, and a software company mostly in cash, receivables and intangible assets. The same ratio can therefore mean different things in each. These mixes are illustrative, not averages for any industry.
How much property and equipment the business needs
Some business models need large amounts of property, plant and equipment before they can sell anything: factories, vehicles, networks or buildings. Others need little more than offices and computers, or they rent what they use and pay other businesses to make their products.
A business with a large asset base usually generates less revenue for each unit of assets, so its asset turnover tends to be lower. For the same profit margin, lower turnover means a lower return on assets. Depreciation is a larger expense for an asset-heavy business, so its EBITDA margin, which leaves depreciation out, and its operating margin, which deducts it, tend to be further apart. The age of the assets matters too: equipment is recorded at cost less accumulated depreciation, so a business with older assets shows a smaller asset base than one that has just invested in similar equipment.
Inventory and how fast it sells
A business that holds stock ties up cash in it until the goods are sold, while a service business may hold almost none. Among businesses that hold stock, everyday or perishable goods usually move quickly, while expensive items that customers buy rarely, or products that take months to build, can sit in stock much longer. A manufacturer also holds raw materials and work in progress.
These differences drive inventory turnover and the number of days stock is held. They also affect liquidity ratios. The current ratio counts inventory as a current asset, while the quick ratio leaves it out. For a business with large stocks the two can be far apart; for a service business they may be almost the same.
Customer and supplier payment terms
A business that sells to consumers who pay at the point of sale has few receivables. A business that sells to other businesses usually invoices them and waits for payment on agreed terms, so receivables build up and days sales outstanding is longer. Customary terms differ between markets, so the same number of days can mean prompt payment in one market and slow payment in another.
Some businesses are paid before they deliver. A subscription business that bills in advance collects cash at the start of each period and records the service it still owes as deferred revenue, a liability that is released into revenue as the service is provided. A large deferred revenue balance raises current liabilities and lowers the current ratio, even though the obligation will usually be settled by delivering the service rather than by paying out cash.
Supplier terms work the same way in reverse. A business that buys on credit and sells quickly for cash can collect from customers before it pays its suppliers. Its cash conversion cycle can then be negative, and its current ratio may look low simply because supplier credit funds part of its operations.
Pricing and cost structure
A business that sells large volumes at low prices often works with thin margins and relies on selling its stock many times a year. A business that sells specialized products in small numbers may earn a much wider margin on each sale but turn its assets over slowly. Both can reach the same return on assets, because return on assets equals net profit margin multiplied by asset turnover, and DuPont analysis separates the two.
Where costs sit in the income statement matters too. The gross profit margin deducts only the cost of goods sold, which for a reseller is mostly the purchase cost of the goods. For a business whose main costs are staff or product development, much of its spending may sit in operating expenses instead, so its gross margin can be wide while its operating margin is much narrower. High fixed costs, such as rent, salaries or depreciation, can also make operating margin swing sharply as sales change, because those costs stay the same while revenue moves.
How the business is financed
Some businesses borrow heavily; others rely mostly on money from their owners. Businesses with predictable cash flows and assets that lenders can take as security, such as property or equipment, often find it easier to borrow, so their debt-to-equity ratio tends to be higher. More borrowing means more interest, which lowers interest coverage. It also raises return on equity when the business earns more on the borrowed money than the interest costs, and lowers it when the business earns less.
Not every liability is borrowing. Deferred revenue and amounts owed to suppliers carry no interest. A debt-to-equity ratio based on total liabilities counts them, while one based on interest-bearing debt leaves them out, so for a business with large customer prepayments or supplier credit the two definitions can give very different results. Some models barely fit standard ratios: for a business that takes deposits and makes loans, ratios built around inventory and trade credit say little.
Accounting choices
Accounting rules allow choices, and businesses in different industries do not always make the same ones. These choices change reported figures without any change in the underlying business:
- Inventory cost methods. First-in, first-out and weighted average cost give different cost of goods sold and inventory values when prices are changing. US GAAP also allows last-in, first-out; IFRS does not.
- Depreciation. The method and useful lives chosen change both expenses and the carrying value of assets.
- Gross or net revenue. A business that acts as an agent, arranging sales for others, records only its commission or fee as revenue, while one that sells as principal records the full price. Similar transaction volumes can produce very different revenue, margins and turnover.
- Development costs. Some development spending can be recorded as an asset rather than an expense, depending on the accounting framework and the nature of the costs.
- Leases. Under IFRS, most lease costs appear as depreciation and interest, which EBITDA leaves out. Under US GAAP, the cost of an operating lease is a single operating expense, which EBITDA includes.
Even within an industry, read the accounting policies in the notes before you compare two businesses closely.
Why comparing like with like matters
Because so much of a ratio comes from structure, a comparison is most informative when the businesses share that structure. A gap between two businesses with different models mostly tells you that the models differ. A gap between two similar businesses is more likely to point to something worth investigating, such as pricing, cost control or collection. To keep comparisons fair:
- Compare a business with itself over several periods first. Its structure usually changes slowly, so movements in its own ratios are easier to interpret.
- Choose comparison businesses with a similar model, not just the same industry label. Two companies classified in the same industry can earn their revenue in very different ways.
- Check that the figures use the same ratio definitions, the same accounting framework and comparable period ends.
- For a business with several distinct divisions, look at segment information if it is reported. Group-level ratios blend the divisions together.
- Treat published industry averages with care. Check which businesses they include, how each ratio is defined and whether the figure is a mean or a median.
No ratio has a single right value for every business. Use ratios to ask why a business looks the way it does, then test the answer against what you know about its model. The guide to the limitations of financial ratio analysis covers other reasons ratios can mislead, and how to analyze financial ratios sets out a step-by-step approach.