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35.1 Ratio Analysis: Liquidity, Solvency, Profitability, Efficiency

Overview​

Ratio analysis uses financial ratios to evaluate business performance. Ratios are calculated from financial statement data and provide insights into liquidity, solvency, profitability, and efficiency. Understanding ratio analysis is essential for evaluating business performance.

Liquidity Ratios​

Current Ratio​

Current Ratio = Current Assets ÷ Current Liabilities

Purpose: Measures ability to pay short-term obligations

Interpretation:

  • > 1.0: Generally good (can pay short-term obligations)
  • < 1.0: May have liquidity problems
  • Too high: May indicate inefficient asset use

Example:

  • Current assets: €50,000
  • Current liabilities: €30,000
  • Current ratio: €50,000 ÷ €30,000 = 1.67 ✅

Quick Ratio (Acid-Test Ratio)​

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

Purpose: Measures ability to pay short-term obligations without selling inventory

Interpretation:

  • > 1.0: Good liquidity without inventory
  • < 1.0: May depend on inventory sales
  • More conservative than current ratio

Example:

  • Current assets: €50,000
  • Inventory: €20,000
  • Current liabilities: €30,000
  • Quick ratio: (€50,000 - €20,000) ÷ €30,000 = 1.0 ✅

Solvency Ratios​

Debt-to-Equity Ratio​

Debt-to-Equity = Total Debt ÷ Total Equity

Purpose: Measures financial leverage and risk

Interpretation:

  • Lower: Less financial risk
  • Higher: More financial risk, more leverage
  • Industry-dependent

Example:

  • Total debt: €100,000
  • Total equity: €150,000
  • Debt-to-equity: €100,000 ÷ €150,000 = 0.67

Debt Ratio​

Debt Ratio = Total Debt ÷ Total Assets

Purpose: Measures proportion of assets financed by debt

Interpretation:

  • Lower: Less debt, more equity
  • Higher: More debt, less equity
  • < 0.5: Generally considered good

Example:

  • Total debt: €100,000
  • Total assets: €250,000
  • Debt ratio: €100,000 ÷ €250,000 = 0.40 (40%)

Profitability Ratios​

Gross Profit Margin​

Gross Profit Margin = (Revenue - Cost of Goods Sold) ÷ Revenue

Purpose: Measures profitability after direct costs

Interpretation:

  • Higher: Better profitability on sales
  • Lower: Lower profitability, may need pricing or cost control
  • Industry-dependent

Example:

  • Revenue: €200,000
  • Cost of goods sold: €120,000
  • Gross profit margin: (€200,000 - €120,000) ÷ €200,000 = 40%

Net Profit Margin​

Net Profit Margin = Net Income ÷ Revenue

Purpose: Measures overall profitability

Interpretation:

  • Higher: Better overall profitability
  • Lower: Lower profitability, may need cost control
  • Industry-dependent

Example:

  • Net income: €20,000
  • Revenue: €200,000
  • Net profit margin: €20,000 ÷ €200,000 = 10%

Return on Assets (ROA)​

ROA = Net Income ÷ Average Total Assets

Purpose: Measures efficiency of asset use

Interpretation:

  • Higher: More efficient asset use
  • Lower: Less efficient asset use
  • Industry-dependent

Example:

  • Net income: €20,000
  • Average total assets: €250,000
  • ROA: €20,000 ÷ €250,000 = 8%

Return on Equity (ROE)​

ROE = Net Income ÷ Average Total Equity

Purpose: Measures return to owners

Interpretation:

  • Higher: Better return to owners
  • Lower: Lower return to owners
  • Industry-dependent

Example:

  • Net income: €20,000
  • Average total equity: €150,000
  • ROE: €20,000 ÷ €150,000 = 13.3%

Efficiency Ratios​

Inventory Turnover​

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Purpose: Measures how quickly inventory is sold

Interpretation:

  • Higher: Faster inventory turnover
  • Lower: Slower inventory turnover, may indicate overstocking
  • Industry-dependent

Example:

  • Cost of goods sold: €120,000
  • Average inventory: €20,000
  • Inventory turnover: €120,000 ÷ €20,000 = 6 times per year

Accounts Receivable Turnover​

Receivable Turnover = Revenue ÷ Average Accounts Receivable

Purpose: Measures how quickly receivables are collected

Interpretation:

  • Higher: Faster collection
  • Lower: Slower collection, may indicate collection problems
  • Industry-dependent

Example:

  • Revenue: €200,000
  • Average receivables: €25,000
  • Receivable turnover: €200,000 ÷ €25,000 = 8 times per year

Accounts Payable Turnover​

Payable Turnover = Cost of Goods Sold ÷ Average Accounts Payable

Purpose: Measures how quickly payables are paid

Interpretation:

  • Higher: Paying suppliers faster
  • Lower: Paying suppliers slower, may indicate cash flow issues
  • Industry-dependent

Luxembourg Compliance Note​

Important Considerations:

  • PCN-based ratios: Ratios calculated from PCN-compliant statements
  • Industry benchmarks: Compare to Luxembourg industry benchmarks
  • Sector-specific: Ratios vary by sector
  • Trend analysis: Analyze trends over time
  • Comparative analysis: Compare to industry and competitors

Think It Through​

Artisan Boulangerie has current assets of €40,000, current liabilities of €25,000, and inventory of €15,000. Calculate current ratio and quick ratio. What do these ratios indicate?

Concepts in Practice​

Ratio Analysis Example

TechLux Solutions ratio analysis:

Liquidity:

  • Current ratio: 1.8 (good liquidity)
  • Quick ratio: 1.2 (good liquidity without inventory)

Solvency:

  • Debt-to-equity: 0.5 (moderate leverage)
  • Debt ratio: 33% (reasonable debt level)

Profitability:

  • Gross profit margin: 45% (good profitability)
  • Net profit margin: 12% (good overall profitability)
  • ROA: 10% (efficient asset use)
  • ROE: 15% (good return to owners)

Efficiency:

  • Inventory turnover: 8 times/year (good turnover)
  • Receivable turnover: 10 times/year (fast collection)
  • Payable turnover: 6 times/year (reasonable payment terms)

Analysis: Strong liquidity, moderate leverage, good profitability, efficient operations.