Financial Ratio Analysis

Overview

Financial ratio analysis transforms raw financial statements into comparable metrics across five categories. Ratios are meaningful only in context — compare against industry benchmarks, historical trends, and peer companies.

When to Use

Trigger conditions:

• User has financial statements and needs to assess company health
• User comparing financial performance across companies
• User performing due diligence or credit analysis
• User asks "is this company financially healthy?" or "analyze these numbers"

When NOT to use:

• For valuation → use DCF or comparables
• For ROE deep-dive → use DuPont Analysis
• For strategic assessment → use SWOT

Framework

IRON LAW: Ratios Without Context Are Meaningless

A current ratio of 1.5 means nothing alone. Is 1.5 good? Compare to:
1. Industry average (retail ~1.2, manufacturing ~1.8)
2. Company's own trend (was it 2.0 last year? → declining liquidity)
3. Peers (competitor has 2.5? → relatively weak)

NEVER report a ratio without at least one comparison point.

IRON LAW: All Five Categories, Every Time

Analyzing only profitability misses a leveraged company about to default.
Analyzing only liquidity misses a profitable company's growth potential.
Cover all five categories for a complete picture.

The Five Categories

1. Profitability — Is the company making money?

Ratio	Formula	Measures
Gross Margin	(Revenue - COGS) / Revenue	Production efficiency
Operating Margin	EBIT / Revenue	Core business profitability
Net Margin	Net Income / Revenue	Bottom-line profitability
ROE	Net Income / Equity	Return to shareholders
ROA	Net Income / Total Assets	Asset productivity

2. Liquidity — Can it pay short-term obligations?

Ratio	Formula	Healthy
Current Ratio	Current Assets / Current Liabilities	> 1.5
Quick Ratio	(Current Assets - Inventory) / Current Liabilities	> 1.0
Cash Ratio	Cash / Current Liabilities	Context-dependent

3. Leverage — How much debt is used?

Ratio	Formula	Measures
Debt-to-Equity	Total Liabilities / Equity	Capital structure
Interest Coverage	EBIT / Interest Expense	Ability to service debt
Debt-to-Assets	Total Liabilities / Total Assets	Asset financing

⚠️ "Debt" definition: This skill (and the bundled script) defines "Debt" in the leverage ratios as Total Liabilities — not "long-term debt only" or "interest-bearing debt only". Both alternative definitions exist in textbooks and produce materially different ratios. If you need a different definition, document the choice explicitly and compute it manually; do not silently substitute.

4. Efficiency — How well are assets used?

Ratio	Formula	Measures
Inventory Turnover	COGS / Avg Inventory	Inventory management
Receivables Turnover	Revenue / Avg Receivables	Collection speed
Asset Turnover	Revenue / Total Assets	Asset productivity
Cash Conversion Cycle	DIO + DSO - DPO	Cash cycle speed

5. Valuation — Is the stock fairly priced?

Ratio	Formula	Measures
P/E	Price / EPS	Price vs earnings
EV/EBITDA	Enterprise Value / EBITDA	Price vs cash generation
P/B	Price / Book Value per Share	Price vs net assets
Dividend Yield	Dividend per Share / Price	Income return

Analysis Process

1. Calculate all relevant ratios from financial statements
2. Compare against industry benchmarks and 3-year trend
3. Identify red flags (declining trends, outliers vs peers)
4. Synthesize a financial health verdict across all five categories
5. Recommend actions based on weak areas

Output Format

⚠️ Decimal vs percent: The bundled script returns all profitability ratios (gross_margin, operating_margin, net_margin, roa, roe) as decimals — 0.35 means 35%, NOT 35.0. Liquidity and leverage ratios are already unitless multiples (e.g. current_ratio: 2.125). Render percentages only in the human-facing markdown report, never in JSON outputs.

# Financial Ratio Analysis: {Company}

## Summary Dashboard
| Category | Status | Key Metric |
|----------|--------|-----------|
| Profitability | 🟢/🟡/🔴 | {headline ratio} |
| Liquidity | 🟢/🟡/🔴 | {headline ratio} |
| Leverage | 🟢/🟡/🔴 | {headline ratio} |
| Efficiency | 🟢/🟡/🔴 | {headline ratio} |
| Valuation | 🟢/🟡/🔴 | {headline ratio} |

## Detailed Ratios
{Tables per category with ratio, value, industry avg, trend}

## Red Flags
- {specific concern with data}

## Overall Assessment
{Synthesized financial health verdict}

Examples

Correct Application

Scenario: Ratio analysis for a Taiwanese electronics manufacturer

Ratio	Company	Industry	Trend	Flag
Gross Margin	18%	22%	↓ from 21%	🔴 Below peers, declining
Current Ratio	1.8	1.5	→ stable	🟢 Adequate
D/E	1.2	0.8	↑ from 0.9	🟡 Rising leverage
Inventory Turnover	4.2x	6.0x	↓ from 5.1x	🔴 Slow inventory

Synthesis: Profitability weakening + inventory building up + leverage rising = potential working capital crisis ahead ✓

Incorrect Application

• Reported "Gross Margin 18%" as standalone fact → No comparison. Is 18% good or bad? Violates Iron Law: ratios without context.
• Only analyzed profitability ratios, missed D/E of 4.5x → Company appeared healthy by margins but was dangerously overleveraged. Violates Iron Law: all five categories.

Gotchas

• Industry matters enormously: A 5% net margin is terrible for software (expect 20-30%) but excellent for grocery retail (expect 2-3%). Always benchmark within industry.
• One-time items: Restructuring charges, asset sales, or legal settlements distort ratios for that period. Use adjusted figures or note the distortion.
• Seasonal businesses: Ratios at different quarter-ends tell different stories. Use trailing 12-month or compare same quarter YoY.
• Off-balance-sheet items: Operating leases (pre-IFRS 16), special purpose vehicles, and contingent liabilities may not appear in standard ratios. Check footnotes.
• Growth companies look "unhealthy": High-growth companies often have low profitability, high leverage, and negative cash flow by design. Context matters.

Scripts

Script	Description	Usage
scripts/financial_ratios.py	Compute standard liquidity, leverage, profitability, and efficiency ratios	python scripts/financial_ratios.py --help

Run python scripts/financial_ratios.py --verify to execute built-in sanity tests.

References

• For industry-specific benchmark ranges, see references/industry-benchmarks.md
• For DuPont deep-dive on ROE, see the biz-dupont skill