In plain English
A ratio puts one number over another so that companies of different sizes can be compared. There are only five families worth knowing at the start: how much profit per krona of sales, how fast things are growing, how much profit per krona invested, whether the bills can be paid, and how much is borrowed.
The advanced view
Ratios are only interpretable against a benchmark — the same company over time, or a peer with the same business model. Return measures mix a period flow with a point-in-time stock, so averaging opening and closing balances matters when the balance sheet moved a lot. DuPont decomposition is the disciplined way to attribute a change in return to margin, turnover or leverage rather than guessing.
In an interview you will not have a calculator, so build every ratio out of 10% and 1% blocks. 10% of 480 is 48; 1% is 4.8. Any percentage is a small sum of those. To divide, round to a friendly number first and adjust: 38/500 is close to 40/500 = 8%, minus a bit, so about 7.6%.
Return on equity is profit divided by what owners put in; return on assets is profit divided by everything the company uses. The gap between them is leverage — borrowing raises ROE when things go well and deepens the hole when they do not. The current ratio (current assets over current liabilities) asks whether next year's bills are covered, and debt-to-equity asks how much of the company is borrowed.
The starter set
Net margin = Net income / Revenue Growth = (New − Old) / Old ROE = Net income / Equity ROA = Net income / Assets Current ratio = Current assets / Current liabilities Debt / Equity = Total debt / Equity
Essential vocabulary
- ROE
- Return on equity — profit as a percentage of the owners' stake. What a shareholder earns on their money.
- ROA
- Return on assets — profit as a percentage of everything the company uses, borrowed or not.
- Leverage
- The use of borrowed money. Multiplies both gains and losses for the owners.
- Liquidity
- How easily the company can pay what falls due soon.
- Benchmark
- The comparison a ratio is judged against — last year, a peer, or the industry.
Common pitfalls
- ×Quoting a ratio with no benchmark. 12% means nothing until you know last year was 18%.
- ×Comparing ROE across companies with very different debt levels and calling the more levered one 'better run'.
- ×Mixing a period number (profit) with a year-end stock (equity) that jumped mid-year without averaging.
Why it works
Dividing by size removes scale, so a corner shop and a listed retailer become comparable. And because the underlying statements obey an identity, ratios built from them decompose exactly — ROE really is margin × turnover × leverage, so the arithmetic itself points at the cause.
How it is used — five ratios in under a minute
Step 1 of 6
- 1Revenue 500, net income 38, equity 200, assets 400.
Deeper
Deeper: DuPont, in three factors and in five
ROE = net income ÷ equity tells you the level, never the reason. The three-factor DuPont splits it: ROE = net margin × asset turnover × equity multiplier. Three businesses can hit 15% ROE in completely different ways — luxury goods with margin, grocery with turnover, banks with leverage — and the strategic read is different in each case.
The five-factor version separates tax and interest: ROE = tax burden (NI/EBT) × interest burden (EBT/EBIT) × operating margin (EBIT/revenue) × asset turnover × equity multiplier. Use it when a company's ROE moved but the operating business did not.
Must know cold
- ✓ROE = net margin × asset turnover × equity multiplier.
- ✓ROIC = NOPAT ÷ invested capital; NOPAT = EBIT × (1 − t).
- ✓Value is created only when ROIC > WACC.
- ✓Always say whether a ratio uses period-end or average balances.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Revenue 500, net income 58.5, total assets 800, equity 450, EBIT 90, tax 22%, non-interest current liabilities 100. Compute ROE, ROIC and the three-factor DuPont.
Exercise 2
Company A: margin 12%, turnover 0.5, multiplier 3.0. Company B: margin 4%, turnover 2.25, multiplier 2.0. Both show 18% ROE. Which is stronger?
Below the crossing point the company loses money on every extra unit of nothing: the fixed costs are still there. Above it, most of each extra krona of revenue falls to profit. That asymmetry is what margin ratios are really telling you about.