Financial statement analysis with ratios

A ratio relates two figures so you can judge one against the other. Ratios fall into four families, each answering a different question.

Liquidity — can the business pay its short-term obligations? - Current ratio = current assets ÷ current liabilities. - Quick (acid-test) ratio = (current assets − inventory) ÷ current liabilities. Inventory is excluded because it must be sold before it becomes cash.

Profitability — how much profit does the business earn from its sales and its capital? - Gross margin = gross profit ÷ revenue; net margin = profit for the year ÷ revenue. - Return on equity (ROE) = profit ÷ average equity; return on assets (ROA) = profit ÷ average total assets.

Efficiency — how well are assets used? - Receivable days (DSO) = receivables ÷ revenue × 365; inventory days (DIO) = inventory ÷ cost of sales × 365. - Inventory turnover = cost of sales ÷ average inventory; asset turnover = revenue ÷ average total assets.

Leverage (gearing) and solvency — how is the business funded, and can it carry the debt? - Debt-to-equity = interest-bearing borrowings ÷ equity. - Interest cover = operating profit ÷ finance costs.

Three rules make ratios useful. Compare — with the prior year, a budget, a covenant or competitors; a ratio alone means little. Be consistent — use averages for balance-sheet figures in return and turnover ratios when you have them, and define debt the same way every year (here: long-term borrowings; lease liabilities are often included too). Since IFRS 16 put almost all leases on the balance sheet, an IFRS lessee shows more debt and higher EBITDA than a US GAAP company with the same operating leases (ASC 842 keeps a single straight-line lease cost in operating expenses), so adjust before comparing leverage across frameworks. Explain — a ratio raises a question; the answer is in the operations. A falling quick ratio with a steady current ratio says current assets are shifting into inventory. Rising ROE can come from better margins or simply more debt.

From 2027 IFRS 18 introduces a defined operating profit subtotal, which makes interest cover and operating margins more comparable between IFRS reporters. Management-defined measures such as "adjusted EBITDA" must be reconciled in a note, so check the definition before using one.