In plain English
Ratios turn big messy numbers into comparable ones. A margin says how much of each sale you keep; a turnover says how hard your assets work; a leverage ratio says how much of the result belongs to lenders.
The advanced view
Ratio analysis is only meaningful as a system: DuPont shows ROE = margin × turnover × leverage, so any change in returns must come from one of three levers. Trend, peer and structural comparisons each answer a different question, and accounting policy differences (leases, capitalised development, revenue timing) must be normalised before comparison.
Financial analysis is diagnosis, not description. The sequence that professionals actually follow is: wealth creation (is the company growing profitably?), then investment (how much capital does that growth consume?), then financing (who funded it and on what terms?), then returns (does the return exceed the cost of the capital?). Anyone can quote a ratio; the skill is ordering ratios into an argument about whether the business model works.
Start with the margin ladder. Gross margin tells you about pricing power and input costs. EBITDA margin adds the fixed cost base and tells you about operating leverage. EBIT margin adds the capital intensity hidden in depreciation. Net margin adds financing and tax. When margins move, isolate which rung moved — a gross-margin fall is a commercial problem, an EBIT-margin fall with flat gross margin is an overhead or capacity problem.
Then look at capital. Capital employed is fixed assets plus working capital; ROCE is EBIT after tax divided by capital employed. Growth that raises revenue but raises capital employed faster destroys value even as profits rise — this is the single most common trap in growth cases. Working capital is the quiet killer: a company can be profitable and still fail because receivables and inventory absorb cash faster than earnings produce it. Read the cash conversion cycle as days: inventory days plus receivable days minus payable days.
Diagnostic ratios
Capital employed = Fixed assets + Working capital ROCE = EBIT × (1 − t) / Capital employed Working capital = Inventory + Receivables − Payables Cash conversion cycle = DIO + DSO − DPO Interest cover = EBIT / Interest expense Net debt / EBITDA (leverage); FFO / Net debt (repayment capacity)
Solvency analysis asks the reverse question: can the company survive its own balance sheet? Three lenses. Liquidity — will cash arrive before obligations fall due (current ratio, quick ratio)? Leverage — how much debt relative to earnings power (net debt / EBITDA, gearing)? Service — can earnings cover the interest (interest cover, FFO / net debt)? Lenders look at the last two; equity analysts often forget them until the covenant breaks.
Essential vocabulary
- Capital employed
- The invested capital the business actually uses: fixed assets plus working capital. The denominator of ROCE.
- Operating leverage
- The ratio of fixed to variable costs. High operating leverage magnifies profit swings from small volume changes.
- Scissors effect
- When revenue and costs grow at different rates, margins move sharply even though both lines look normal individually.
- DSO / DIO / DPO
- Days sales outstanding, days inventory outstanding, days payables outstanding. The three components of the cash cycle.
- Covenant
- A contractual ratio limit in a loan (typically net debt / EBITDA or interest cover). Breaching it hands control to lenders.
- Quality of earnings
- How closely reported profit tracks cash. Widening gaps between net income and operating cash flow are a red flag.
Strategy connection
Sustained ROCE above the cost of capital is the financial signature of a competitive advantage. When you find it, ask which advantage produces it — pricing power shows in gross margin, scale shows in overhead ratios, and asset-light models show in capital turns. When ROCE is falling while revenue grows, the strategy is buying volume with capital.
Intuition
Ratio analysis is triage. Margins tell you about pricing and cost, turnover tells you about asset productivity, and the cash conversion cycle tells you whether growth funds itself. Always compare against the company's own history first and the peer set second — levels mean little, direction and gap mean a lot.
Common pitfalls
- ×Comparing ratios across companies with different accounting policies (leases, capitalised development).
- ×Using revenue rather than cost of goods sold for inventory days.
- ×Celebrating a longer payables cycle that is actually late payment to suppliers.
- ×Reading a rising current ratio as strength when it is unsold inventory.
Worked example — cash conversion cycle
Step 1 of 5
- 1Revenue 900, COGS 600, receivables 150, inventory 100, payables 90
Why it works
The decomposition works because the ratios telescope: (NI/Sales)×(Sales/Assets)×(Assets/Equity) cancels back to NI/Equity exactly. That algebraic identity is what lets you attribute a fall in ROE to pricing, to asset efficiency, or to deleveraging without any extra data.
How it is used — diagnose a falling ROE
Step 1 of 4
- 1ROE falls 15% → 12%. Margin 6% → 5%, turnover 1.25 → 1.25, leverage 2.0 → 1.92.
Deeper
Deeper: diagnosing a margin decline in four moves
Ratio analysis is only useful as a diagnostic sequence. First, isolate whether the change is revenue or cost. Second, split revenue into price, volume and mix. Third, split cost into variable and fixed, and check whether the fixed base grew. Fourth, check working capital and capex to see whether the profit is cash.
Always benchmark three ways: against the company's own history, against peers, and against the economics of the business (a grocer at 30% EBIT margin is a data error). Trends beat levels; two data points is a line, three is a trend.
Must know cold
- ✓Margin bridge = price + volume + mix + cost + overhead, summing to the change.
- ✓Common-size everything: state each line as a % of revenue before comparing.
- ✓Check operating cash flow against net income over three years for earnings quality.
- ✓Use averages, not year-end balances, for turnover ratios in growing firms.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
EBIT fell from 50 to 38. Price +6, volume −4, mix −2, input cost −9, overhead −3. What is your one-sentence read, and what do you do next?
Exercise 2
Net income grew 12% a year for three years while operating cash flow was flat. Name three explanations and how to test each.
Plot the driver against the outcome across peers and the fitted line becomes the expectation; the residual is the company-specific story. That residual — not the raw ratio — is the finding worth a slide.