Ratio analysis (liquidity, solvency, profitability)

 

Ratio analysis is a powerful tool to evaluate a company’s financial health across three main dimensions:

🔹 Liquidity – Can the company meet short-term obligations?
🔹 Solvency – Can the company meet long-term obligations?
🔹 Profitability – How efficiently is the company generating profits?

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🧪 1. Liquidity Ratios

These assess a firm’s ability to pay short-term liabilities.

Ratio	Formula	Ideal Range	Interpretation
Current Ratio	Current Assets / Current Liabilities	> 1.2	Indicates if the firm can cover short-term liabilities
Quick Ratio (Acid-Test)	(Current Assets – Inventory) / Current Liabilities	> 1	Excludes inventory to assess more liquid coverage
Cash Ratio	Cash & Cash Equivalents / Current Liabilities	0.5–1	Measures the company’s most liquid assets

✔️ Healthy liquidity: Current ratio > 1, Quick ratio > 1
🚩 Red flag: Low ratios may indicate working capital issues

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🧱 2. Solvency Ratios (Leverage Ratios)

These evaluate a company’s ability to meet long-term obligations.

Ratio	Formula	Ideal Range	Interpretation
Debt-to-Equity (D/E)	Total Debt / Shareholders’ Equity	< 1 (depends on industry)	Measures reliance on debt vs. equity
Interest Coverage Ratio	EBIT / Interest Expense	> 3	Measures how easily a company can pay interest on debt
Debt Ratio	Total Liabilities / Total Assets	< 0.6	Shows what proportion of assets are financed through debt

✔️ Strong solvency: Low D/E ratio, high interest coverage
🚩 Red flag: High leverage = higher financial risk

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💸 3. Profitability Ratios

These measure how well a company generates profits from operations and assets.

Ratio	Formula	Benchmark	Interpretation
Gross Profit Margin	(Revenue – COGS) / Revenue × 100	Higher is better	Indicates core profitability before operating costs
Operating Margin	Operating Profit / Revenue × 100	Varies by sector	Shows efficiency after operating expenses
Net Profit Margin	Net Profit / Revenue × 100	10%+ ideal	Overall profitability after all expenses
Return on Assets (ROA)	Net Profit / Total Assets × 100	> 5%	How efficiently assets generate profit
Return on Equity (ROE)	Net Profit / Shareholder Equity × 100	> 15%	Measures profitability for shareholders

✔️ Healthy firm: High margins, ROA, and ROE
🚩 Low margins: May indicate cost inefficiency or low pricing power

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📊 Example Snapshot (Hypothetical)

Metric	Value	Interpretation
Current Ratio	1.5	Good liquidity
Quick Ratio	1.1	Stable liquid position
D/E Ratio	0.8	Balanced leverage
Interest Coverage	4.5	Easily covering debt interest
Net Profit Margin	12%	Strong profitability
ROE	18%	Attractive to shareholders

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✅ Tips for Effective Ratio Analysis

• Always compare ratios with industry averages.

• Use trend analysis (year-over-year) to spot improvements or declines.

• Combine with cash flow and financial statements for a complete view.