Estimated study time: 45 minutes
Content:
Financial ratio analysis is the primary quantitative tool for evaluating company performance, financial health, and valuation. Ratios are most useful when compared across time (trend analysis) and against industry peers (cross-sectional analysis), since absolute numbers in isolation rarely tell a complete story. The DuPont analysis framework decomposes return on equity (ROE) into its component drivers: ROE = Net Profit Margin × Asset Turnover × Financial Leverage (Equity Multiplier). In its extended form: ROE = (Net Income / EBT) × (EBT / EBIT) × (EBIT / Revenue) × (Revenue / Assets) × (Assets / Equity). This decomposition reveals whether ROE is driven by strong margins, efficient asset use, or high leverage — critical for understanding the sustainability and quality of profitability.
Liquidity ratios measure a company's ability to meet short-term obligations. The current ratio = Current Assets / Current Liabilities; a ratio below 1.0 signals potential liquidity stress. The quick ratio (acid test) = (Cash + Short-term investments + Receivables) / Current Liabilities; this excludes inventory (which may not be quickly liquidable) and is a more conservative liquidity measure. The cash ratio = (Cash + Short-term investments) / Current Liabilities is the most stringent. The cash conversion cycle (CCC) = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO) measures how many days it takes to convert inventory investment into cash; a shorter CCC is more favorable. High CCC relative to peers can indicate working capital inefficiency or aggressive revenue recognition.
Solvency ratios evaluate long-term financial stability and the company's ability to service debt. The debt-to-equity ratio = Total Debt / Total Equity; higher values indicate more financial leverage and more risk. The debt-to-assets ratio = Total Debt / Total Assets. Interest coverage ratio = EBIT / Interest Expense (or EBITDA / Interest Expense for a more generous measure); this tells how many times the company can cover its interest payments from operating earnings — a ratio below 1.5x raises serious default risk concerns. The fixed charge coverage ratio extends interest coverage to include lease payments and other fixed obligations. Analysts use these ratios to estimate the probability of financial distress and to assess covenant compliance for existing debt.
Activity (efficiency) ratios measure how effectively a company uses its assets. Asset turnover = Revenue / Average Total Assets; higher values indicate more revenue generated per dollar of assets. Inventory turnover = COGS / Average Inventory; high turnover indicates efficient inventory management (but can also signal stockout risk if too high). Receivables turnover = Revenue / Average Accounts Receivable. These turnover ratios can be converted to "days" metrics: DIO = 365 / Inventory Turnover; DSO = 365 / Receivables Turnover; DPO = 365 / (COGS / Average Payables). Profitability ratios include gross margin, operating margin, net margin, ROA = Net Income / Average Total Assets, and ROE = Net Income / Average Total Equity. Together, these ratios provide a comprehensive picture of operational efficiency and return generation.
Key Terms:
Quiz Questions:
Q1. Company X has a net profit margin of 8%, an asset turnover of 1.5, and an equity multiplier of 2.0. What is Company X's ROE using the DuPont formula?
A) 12% B) 24% C) 16% D) 20%
Answer: B — ROE = Net Profit Margin × Asset Turnover × Equity Multiplier = 8% × 1.5 × 2.0 = 24%. This DuPont decomposition shows that Company X achieves its 24% ROE through a combination of moderate margins, solid asset efficiency, and 2:1 financial leverage. An analyst should assess whether the leverage is sustainable and whether the 8% margin is stable.
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Q2. A company has current assets of $400M (including $100M of inventory and $50M of prepaid expenses), and current liabilities of $200M. What is the quick ratio?
A) 2.0 B) 1.25 C) 1.5 D) 0.75
Answer: B — Quick ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities = ($400M – $100M – $50M) / $200M = $250M / $200M = 1.25. Prepaid expenses are excluded along with inventory because they cannot be quickly converted to cash to meet obligations. A quick ratio of 1.25 means the company has $1.25 of liquid assets for every $1.00 of current liabilities.
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Q3. A retailer has Days Sales Outstanding (DSO) of 5 days, Days Inventory Outstanding (DIO) of 60 days, and Days Payable Outstanding (DPO) of 45 days. What is the cash conversion cycle?
A) 20 days B) 110 days C) 65 days D) 45 days
Answer: A — CCC = DSO + DIO – DPO = 5 + 60 – 45 = 20 days. The company takes 60 days to sell inventory, collects receivables in 5 days, but takes 45 days to pay suppliers. The net cash investment period is only 20 days. Retailers often have negative CCC (they collect cash before paying suppliers), which actually provides them with a financing advantage.
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Q4. Two companies in the same industry have identical ROE of 20%. Company A achieves this with a net margin of 10%, asset turnover of 1.0, and equity multiplier of 2.0. Company B achieves 20% ROE with a net margin of 4%, asset turnover of 2.5, and equity multiplier of 2.0. Which company's ROE is more sustainable?
A) Company B, because high asset turnover is the most reliable ROE driver B) Company A, because high-margin businesses are more defensible and less sensitive to revenue decline C) They are equally sustainable since ROE is the same D) Neither, because both use 2x leverage which is unsustainable
Answer: B — Company A's high-margin, low-turnover model is generally more defensible because margins can be protected through brand strength, pricing power, or switching costs. Company B's razor-thin 4% margin leaves almost no buffer for cost increases, competitive pressure, or revenue declines — a small margin compression could collapse ROE. This DuPont analysis insight helps analysts assess the quality and durability of profitability, not just its current level.
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Q5. A company has EBIT of $50M, interest expense of $20M, and operating lease payments (treated as fixed charges) of $10M. What is the fixed charge coverage ratio?
A) 2.5x B) 1.67x C) 2.0x D) 1.83x
Answer: B — Fixed charge coverage = (EBIT + Fixed charges) / (Interest expense + Fixed charges) = ($50M + $10M) / ($20M + $10M) = $60M / $30M = 2.0x. Wait — the standard formula is EBIT / (Interest + Fixed charges) = $50M / ($20M + $10M) = $50M / $30M = 1.67x. The correct answer is B (1.67x), using EBIT in the numerator and total fixed charges in the denominator. A ratio of 1.67x means the company covers its total fixed obligations 1.67 times — adequate but not generous, especially in a downturn.
Answer: B — Fixed charge coverage = EBIT / (Interest Expense + Fixed Charges) = $50M / ($20M + $10M) = $50M / $30M ≈ 1.67x. This ratio is lower than the basic interest coverage (50/20 = 2.5x) because it incorporates operating lease payments as additional fixed obligations. Lenders and analysts use this broader ratio to assess whether the company can sustain its full obligation structure.
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