BUSS1030 · Accounting For Decision Making
Ratio Analysis
A single figure means little on its own; ratios put statement figures into relation so users can judge liquidity (can it pay its bills?), efficiency (is it using its assets hard?), profitability (is the return satisfactory?) and capital structure (how much does it rely on debt?). This chapter gives each ratio’s formula, what it tells a decision-maker, and the interpretation trap — then works a compact panel on the same business as the statements and cash-flow chapters. The golden rule runs through everything: a ratio is only meaningful when compared (to a trend, a peer or a budget), and the skill the exam rewards is the interpretation, not the bare number. Two high-yield mechanics: use average balances for any turnover or return ratio, and remember “higher is better” is not universal.
What this chapter covers
- 0110.1 The golden rule — a ratio means nothing alone; benchmarks
- 02Average vs ending balances; grouping ratios by the decision
- 0310.2 Liquidity — current and quick (acid-test) ratios
- 0410.3 Efficiency / turnover — inventory, receivables, asset (use averages)
- 0510.4 Profitability — margins, ROA, ROE, operating-cash-flow margin
- 0610.5 Capital structure — debt-to-equity; the leverage signature
- 07Writing the interpretation (where the marks are)
Worked example: compute a ratio, then interpret it
- +1(a) Current ratio. = current assets ÷ current liabilities = $106,000 ÷ $26,000 = 4.1 : 1.
- +2(a) Quick ratio. = (current assets − inventory − prepaid) ÷ current liabilities = ($106,000 − $44,000 − $3,000) ÷ $26,000 = $59,000 ÷ $26,000 = 2.3 : 1.
- +1(b) Interpret the current ratio. 4.1 : 1 is strong short-run cover — ample current assets to meet short-term debts — but so high it is worth checking for idle cash or slow inventory.
- +1(b) Interpret the quick ratio. 2.3 : 1 shows the business can still cover current liabilities more than twice over using only near-cash assets, even excluding inventory and prepaid — comfortable liquidity for a creditor.
Key terms
- Liquidity ratios
- Measure short-run survival — how readily assets convert to cash to meet obligations as they fall due. The current ratio (current assets ÷ current liabilities) and the quick/acid-test ratio (near-cash current assets ÷ current liabilities) are the two; both are about the short run only.
- Turnover (activity) ratios
- Measure operating capability — how fast the business sells inventory, collects receivables and generates sales from its asset base (inventory turnover, receivables turnover, asset turnover). They mix a period flow with a point-in-time balance, so use the average balance.
- Return on equity (ROE)
- Net income ÷ average owner’s equity — the return earned on the owner’s own stake, the investor’s headline number. ROE above ROA is the footprint of leverage: borrowed money lifts the owner’s return when assets earn more than the loan costs.
- Operating cash flow margin
- Net cash from operating activities ÷ net sales — cents of cash generated per sales dollar. It is both a profitability and a liquidity measure, and the bridge between the income statement and the cash flow statement.
- Debt-to-equity
- Total liabilities ÷ owner’s equity — dollars of debt per dollar of owner funds, a long-run capital-structure measure. Higher means more financial risk but can amplify ROE; “low is always safe” is wrong — the right level is industry- and stability-dependent.
Ratio Analysis FAQ
Why is a ratio meaningless on its own?
Because a number like “current ratio 1.8” or “ROE 18%” is neither good nor bad until you compare it — to a trend (this year vs prior years), a peer / industry benchmark, or a budget / target. Industries differ structurally: a supermarket should have a thin net margin and fast turnover; a jeweller the reverse. Quoting a ratio with no benchmark, or against the wrong benchmark, are the two recurring failures — and a bare number with no interpretation loses the marks.
When do I use average balances instead of ending balances?
Whenever a ratio mixes an income-statement figure (a period flow) with a balance-sheet figure (a point-in-time stock) — that is, any turnover or return ratio (inventory turnover, receivables turnover, asset turnover, ROA, ROE). Use the average = (opening + closing) ÷ 2, so the period flow is matched to a period-average stock. Using the ending balance is the single most common turnover error.
Is higher always better for a ratio?
No. A high inventory or receivables turnover is generally good (cash isn’t tied up), but at extremes it can imply stock-outs and lost sales, or credit terms so tight they drive customers away. A very high current ratio can mean idle cash or bloated inventory. A high ROE driven by heavy debt magnifies losses in a bad year. Always pair the number with a benchmark and read it alongside related ratios before judging.
What does it mean when ROE is higher than ROA?
It is the signature of leverage. ROE (return on the owner’s stake) sits above ROA (return on all assets) when the business earns more on its assets than its borrowings cost — borrowed money lifts the owner’s return. The same leverage magnifies losses in a bad year, so a high ROE driven by heavy debt is not unambiguously good. Read it alongside debt-to-equity and the liquidity ratios.
Exam move
Practise the full panel on one set of statements and write an interpretation for every ratio — state the number, name a benchmark, draw the decision — because that is where the marks live. Group the ratios by the decision-maker (creditors: liquidity and debt-to-equity; investors: profitability and ROE; managers: efficiency and operating-cash-flow margin) so you reach for the right one. Use average balances for every turnover and return ratio, and quote either turnover or days (they are reciprocals scaled by 365) but never a contradictory pair. Resist “higher is better” reflexes, spot the leverage signature (ROE above ROA, read with debt-to-equity), and tie the cash margin back to the accrual gap (operating-cash-flow margin below net profit margin is the same gap the cash-flow chapter exposed, now as a ratio).
