The three statements told you the raw numbers. Ratios turn them into judgement: Is this company healthy? Can it pay its debts? Is it actually making money? One number alone means nothing — a ratio gives it context.
1The big idea
A ratio is a number with context
"$5 million profit" tells you almost nothing. $5m on $10m of sales is fantastic; on $5 billion it's a disaster. A ratio puts one number over another to reveal the truth.
Always compareA ratio only means something relative to something else: prior years (trend), competitors (benchmark), or industry norms.
Direction mattersFor each ratio, know whether higher or lower is "good" — and that it's context-dependent (too high can also be bad).
Memory hook 🧠"Compared to what?" — ask it every single time. A ratio with no comparison point is just trivia.
2The map
The Five Families of Ratios
Every ratio you'll ever meet falls into one of five buckets, each answering a different question about the business.
💧 Liquidity
Can it pay short-term bills?
from: Balance Sheet
⚖️ Leverage / Solvency
Can it survive its debt long-term?
from: Balance Sheet + P&L
💰 Profitability
Does it make good money?
from: Income Statement
⚙️ Efficiency / Activity
Does it use assets well?
from: P&L + Balance Sheet
📈 Valuation (market)
Is the share price cheap or rich? (e.g. P/E ratio) — covered later in Finance.
Can the company cover what's due soon with what it can quickly turn to cash? This is the "will it survive the next 12 months" check.
Current Ratio ≥1 good
Current AssetsCurrent Liabilities
>1 means it can cover short-term bills. ~1.5–3 is healthy. Too high = idle cash.
Quick Ratio stricter
Current Assets − InventoryCurrent Liabilities
The "acid test." Strips out inventory (slow to sell). Closer to true instant liquidity.
Memory hook 🧠Quick = Current minus the slow stuff. Inventory can't pay this week's wages, so the quick ratio ignores it.
4Family 2 · long-term risk
⚖️ Leverage / Solvency Ratios
How much does the company rely on borrowed money? Debt amplifies returns when times are good and sinks you when they're bad — these ratios measure that risk.
Debt-to-Equity lower=safer
Total DebtTotal Equity
How many $ of debt per $ of owners' money. >2 often signals high risk (industry-dependent).
Interest Coverage higher=safer
EBITInterest Expense
How many times profit covers the interest bill. <1.5 = danger; the firm barely earns its interest.
The double edgeLeverage is a magnifier: borrow at 5%, earn 15% on it → owners win big. But if returns drop below the interest cost, losses magnify just as fast. That's financial risk.
5Family 3 · making money
💰 Profitability Ratios
Of every dollar that comes in, how much sticks? And how good a return does the company earn on what's invested in it? These come straight off the income-statement waterfall.
Gross Margin
Gross ProfitRevenue
% left after direct product costs. Reveals pricing power.
Net Margin
Net IncomeRevenue
The final % of sales kept as profit — the bottom of the waterfall.
ROA return on assets
Net IncomeTotal Assets
Profit earned per $ of assets. How well it uses its resources.
ROE return on equity
Net IncomeShareholders' Equity
The headline number for owners: return on their money.
Memory hook 🧠Margins ask "per dollar of sales"; returns (ROA/ROE) ask "per dollar invested." Same profit, two different denominators.
6Family 4 · using assets well
⚙️ Efficiency / Activity Ratios
How hard is the company working its assets? Fast turnover = less cash tied up, more sales per asset.
Inventory Turnover
COGSAvg Inventory
How many times stock is sold & replaced per year. Higher = leaner. Too high may mean stockouts.
Days Sales Outstanding
Accounts ReceivableRevenue × 365
Average days to collect cash from customers. Lower = you get paid faster.
Asset Turnover
RevenueTotal Assets
Sales generated per $ of assets. Key lever in DuPont (next).
Days Inventory
365 ÷ Inventory Turnover
Average days stock sits before selling. Feeds the working-capital cycle.
7★ The elegant one
DuPont Analysis: cracking open ROE
ROE is the headline, but it hides how a company earns its return. DuPont breaks ROE into three levers — so you can see whether a high ROE comes from fat margins, hard-working assets, or just lots of debt.
Three levers multiply to ROE. Two firms with identical ROE can be totally different underneath.
① Net Margin"We earn fat profit on each sale." High-margin route (e.g. luxury, software).
② Asset Turnover"We sell a huge volume per asset." Efficiency route (e.g. supermarkets, discount retail).
③ Equity Multiplier"We use lots of debt to amplify returns." Leverage route (e.g. banks) — but it adds risk.
Why this matters ⚠️A dazzling ROE driven mostly by the equity multiplier is a borrowed-money mirage — fragile in a downturn. DuPont exposes whether the return is earned or leveraged.
Memory hook 🧠"Margin × Turnover × Leverage." Sell rich, sell often, or borrow big — three paths to the same headline ROE.
8The cash tied up in operations
Working Capital & the Cash Cycle
Working Capital = Current Assets − Current Liabilities. It's the money locked up running day-to-day operations. The faster cash flows through the cycle, the less you need to finance.
Cash Conversion CycleCCC = Days Inventory + Days Receivables − Days Payables. The number of days your cash is "trapped" before coming back. Some giants (Amazon) run it negative — they get paid before paying suppliers.
9Putting it to work
Red Flags & How to Analyse
Your roadmap deliverable is to compute 6 ratios for a real company. Here's how a pro reads them — and the warning signs that matter.
Trend > snapshotOne year is a photo; 3–5 years is the story. Look for ratios deteriorating over time.
BenchmarkCompare to direct competitors and the industry average — "good" varies wildly by sector.
Cross-checkNo single ratio decides anything. Read them as a system; they should tell a consistent story.
Classic red flags ⚠️Rising profit but falling operating cash flow · receivables growing faster than sales (channel stuffing) · current ratio drifting below 1 · interest coverage near 1 · margins quietly eroding year over year.
Tie it together 🧠You now read the statements (M4) and judge them (M5). Next up — Managerial Accounting: costs, contribution margin & break-even — the numbers for decisions inside the firm.
🎯 Active recall
Cover the answer, say it aloud, then tap to check. The big one: re-draw the DuPont tree and the cash cycle from memory. Revisit today, +3 days, +1 week.
Why is a single number (like "$5m profit") meaningless without a ratio?
Because profit only matters relative to scale. $5m on $10m sales is great; on $5bn it's terrible. A ratio supplies the context — always ask "compared to what?"
Both = current assets ÷ current liabilities, but the quick ratio removes inventory first (the "acid test"), since inventory is slow to convert to cash.
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What does interest coverage tell you, and what's dangerous?
EBIT ÷ interest expense — how many times profit covers the interest bill. Below ~1.5 is risky; the firm barely earns enough to pay its lenders.
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Difference between a margin and a return (ROA/ROE)?
Margins are profit per dollar of SALES (revenue denominator). Returns are profit per dollar INVESTED (assets or equity denominator).
If it's driven mainly by the equity multiplier (lots of debt) rather than margin or turnover, the return is leveraged and fragile — it can collapse in a downturn.
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What is the Cash Conversion Cycle?
CCC = Days Inventory + Days Receivables − Days Payables. The number of days cash is tied up in operations before returning. Shorter is healthier; negative (e.g. Amazon) is excellent.
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Module 5 of your MBA · Phase 2 · Re-draw the DuPont tree from memory before moving on. 📐