Financial Statement Analysis: The Essential Ratios

Financial Statement Analysis: The Essential Ratios

Financial ratio analysis is the first reflex of every analyst faced with a new company. Through a few key numbers, you can assess a company's profitability, stability, and operational efficiency.

The Three Financial Statements

• Income Statement: Performance over a period (Revenue, EBITDA, Net Income)
• Balance Sheet: Snapshot of assets, liabilities, and equity at a given date
• Cash Flow Statement: Actual cash movements (operating, investing, financing)

Profitability Ratios

Gross Margin

Gross Margin = (Revenue - COGS) / Revenue × 100

Benchmarks: SaaS (70-85%), Retail (25-40%), Manufacturing (20-35%)

EBITDA Margin

EBITDA Margin = EBITDA / Revenue × 100

Key indicator of operating profitability, independent of financial and tax structure.

ROE (Return on Equity)

ROE = Net Income / Shareholders' Equity × 100

Measures return for shareholders. ROE > 15% is generally considered good.

DuPont Decomposition

ROE = Net Margin × Asset Turnover × Financial Leverage
    = (NI/Rev) × (Rev/Assets) × (Assets/Equity)

Reveals where profitability comes from: margins, operational efficiency, or leverage.

Liquidity Ratios

Current Ratio

Current Ratio = Current Assets / Current Liabilities

Should be > 1. A ratio between 1.5 and 2.5 is healthy.

Quick Ratio

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

More conservative as it excludes inventory. A ratio > 1 is reassuring.

Solvency Ratios

Interest Coverage Ratio (ICR)

ICR = EBITDA / Interest Expense

ICR < 2 is a warning signal. Bank covenants typically require ICR > 3.

Net Debt / EBITDA

The most monitored leverage ratio.

Efficiency Ratios

Cash Conversion Cycle (CCC)

CCC = DSO + DIO - DPO

Measures days between cash outflow for purchases and cash inflow from sales. Shorter is better.

Red Flags to Watch

• Current ratio < 1 and declining
• ICR < 2
• Rising DSO quarter over quarter
• Eroding gross margins
• Working capital growing faster than revenue

Conclusion

Ratio analysis is powerful but requires context. A single ratio says nothing — it is the combination of ratios, their evolution over time, and peer comparison that creates insight.

Our Financial Statements Excel template automates all ratio calculations with trend charts and an alert system.