Financial ratios: comparing companies of any size
A ratio divides one number from the statements by another. That simple step lets you compare a corner bike shop with a national chain, or this year with five years ago. This lesson computes the most useful ratios for one small company and shows where they can mislead you.
Why divide?
A company with $2 million of sales and one with $2 billion can’t be compared dollar for dollar. Divide, though, and size drops out. Ten cents of profit per sales dollar means the same thing at either size.
Every number below comes from Pebble Creek Bikes, the made-up company in the income statement, balance sheet and cash flow lessons. This year it had revenue of $2,000,000, operating income of $200,000, interest expense of $40,000 and net income of $120,000. At year end it had total assets of $2,000,000, equity of $1,000,000, bank debt of $700,000, current assets of $800,000 and current liabilities of $400,000.
Profit ratios
The three margins divide a profit line by revenue: gross margin 40%, operating margin 10%, net margin 6%.
Return on assets (ROA) is net income ÷ total assets. It asks how much profit the company squeezes out of everything it owns. Pebble Creek: $120,000 ÷ $2,000,000 = 6%.
Return on equity (ROE) is net income ÷ shareholders’ equity. It asks how much profit the company earns on the owners’ money. Pebble Creek: $120,000 ÷ $1,000,000 = 12%.
Return on equity in three parts
A high ROE can come from very different places. A method named after DuPont, the company where it was first used, splits it into three ratios that multiply together:
- Net margin: how much profit each sales dollar leaves behind.
- Asset turnover: how many dollars of sales each dollar of assets brings in (revenue ÷ total assets).
- Equity multiplier: how many dollars of assets sit on each dollar of owners’ money (total assets ÷ equity). The higher it is, the more the company leans on borrowed money.
In plain words: earn a good slice on each sale, sell a lot with what you own, and use some borrowed money. All three lift ROE. Only the first two come from running a better business. The third adds risk.
Pebble Creek’s ROE, built from its three parts:
- Net margin: $120,000 ÷ $2,000,000 = 6%.
- Asset turnover: $2,000,000 ÷ $2,000,000 = 1.0.
- Equity multiplier: $2,000,000 ÷ $1,000,000 = 2.0.
- ROE: 6% × 1.0 × 2.0 = 12%, the same answer as $120,000 ÷ $1,000,000.
Last year, using last year’s income statement and the start-of-year balance sheet: net margin $105,000 ÷ $1,500,000 = 7%; asset turnover $1,500,000 ÷ $1,750,000 = about 0.86; equity multiplier $1,750,000 ÷ $900,000 = about 1.94. ROE: 7% × 0.86 × 1.94 = about 11.7%.
So ROE rose a little, from 11.7% to 12%. But the margin fell. The gain came from assets working harder and a bit more borrowing, not from more profit per bike.
Safety ratios
Debt-to-equity is total debt ÷ equity. It shows how much the company has borrowed for every dollar the owners have in. Pebble Creek: $700,000 ÷ $1,000,000 = 0.7.
Interest coverage is operating income ÷ interest expense. It shows how many times over the business could pay its interest bill. Pebble Creek: $200,000 ÷ $40,000 = 5. A number near 1 means almost every dollar of operating profit goes to lenders.
The current ratio is current assets ÷ current liabilities. It compares what should turn into cash within a year with the bills due within a year. Pebble Creek: $800,000 ÷ $400,000 = 2.0.
An efficiency ratio
Asset turnover, from the breakdown above, deserves its own spot. A taco truck that sells out every day turns a small set of assets over quickly. A railroad with thousands of miles of track turns its assets slowly. Neither is wrong; they’re different businesses.
Compare over time
One year’s ratio is a single photo. Line up several years and you see the direction.
| Pebble Creek | Last year | This year |
|---|---|---|
| Gross margin | 42% | 40% |
| Operating margin | 11% | 10% |
| Net margin | 7% | 6% |
| Return on assets | 6.0% | 6.0% |
| Return on equity | 11.7% | 12.0% |
| Debt-to-equity | 0.67 | 0.70 |
| Interest coverage | 6.6 | 5.0 |
| Current ratio | 1.71 | 2.00 |
| Asset turnover | 0.86 | 1.00 |
The picture is mixed. Margins and interest coverage slipped, and debt crept up. Turnover and the current ratio improved.
Compare with similar companies
Now set Pebble Creek next to Granite Trail Bicycles, another made-up bike maker. Say Granite Trail has a net margin of 9%, asset turnover of 0.8 and an equity multiplier of 1.5. Its ROE is 9% × 0.8 × 1.5 = 10.8%, a bit below Pebble Creek’s 12%.
The breakdown shows why. Granite Trail earns more on each sale and borrows less. Pebble Creek’s higher ROE rests partly on debt. Higher return and higher risk travel together here.
Pitfalls
- Recipes differ. Some sites count all liabilities as debt. Pebble Creek’s debt-to-equity is then $1,000,000 ÷ $1,000,000 = 1.0, not 0.7. Some use average equity for ROE: $120,000 ÷ $950,000 = about 12.6%. Check the recipe before comparing numbers from two sources.
- A ratio can improve for a bad reason. Pebble Creek’s current ratio rose from 1.71 to 2.00, which looks safer. But it rose because unsold bikes and unpaid customer bills piled up while cash fell.
- One-time items can bend a single year’s margins up or down.
- Industries differ. Compare bike makers with bike makers.
- Tiny or negative equity makes ROE huge or meaningless.
- Ratios look backward. They describe the last report, not the next one.
- Ratio
- One number divided by another, so companies of different sizes can be compared.
- Return on assets (ROA)
- Net income divided by total assets.
- Return on equity (ROE)
- Net income divided by shareholders’ equity.
- Asset turnover
- Revenue divided by total assets.
- Equity multiplier
- Total assets divided by equity; a measure of how much a company leans on borrowing.
- Debt-to-equity
- Total debt divided by equity.
- Interest coverage
- Operating income divided by interest expense.
- Current ratio
- Current assets divided by current liabilities.
Where to see it on Filing.fyi
The Piotroski F-Score card is largely a ratio checklist. Several of its nine tests are ratios from this lesson: is return on assets positive and higher than last year, did the current ratio go up, did gross margin improve, did asset turnover improve, and did long-term debt shrink compared with assets? On Pebble Creek’s numbers, the current ratio and turnover tests pass, the gross margin test fails, and return on assets stayed flat at 6%, so it is positive but did not improve. (The site’s recipe for each test may differ slightly from the simple versions here.) The Altman Z-Score is built from ratios too. For the raw numbers behind any ratio, open the 10-K or 10-Q from the company page’s filing timeline.
- Ratios remove size, so a small company can be compared with a giant.
- ROE = net margin × asset turnover × equity multiplier; check which part is doing the work.
- Debt-to-equity, interest coverage and the current ratio measure safety.
- Compare a company with its own past and with similar businesses, using the same recipe.
- Ask why a ratio moved; an improvement can hide a problem.
This lesson is education, not investment advice. Examples use made-up companies and round numbers unless a real filing is named.