======Financial Ratio Analysis======
Financial Ratio Analysis is the art and science of using a company's financial data to peel back the layers and understand what’s //really// going on inside. Think of it as a financial health check-up for a business. Instead of just looking at a single, giant number like total revenue, an investor uses ratio analysis to compare different numbers from the [[Income Statement]], [[Balance Sheet]], and [[Cash Flow Statement]]. This process creates a set of "vital signs"—ratios—that reveal a company's strengths and weaknesses. For a [[Value Investing]] practitioner, this isn't just a nerdy accounting exercise; it's a fundamental part of the detective work. Legendary investors from [[Benjamin Graham]] to [[Warren Buffett]] have built their fortunes on this kind of deep-dive analysis. It transforms raw, and often intimidating, financial reports into actionable insights, helping you to judge a company's profitability, liquidity, efficiency, and debt burden. It's about moving beyond the headlines and understanding the true story the numbers are telling.
===== Why Bother with Ratios? =====
A number in isolation is just a number. Is $10 million in profit good? It’s impossible to say. But if you know that profit came from only $20 million in revenue, that’s a spectacular 50% profit margin! Ratios provide that crucial context. They are the investor's secret weapon for two key reasons:
  * **Comparability:** Ratios allow you to make meaningful comparisons. You can compare a company’s performance against its own history (//Trend Analysis//) to see if it's improving or declining. You can also compare it to its direct competitors or the industry average (//Industry Analysis//) to see if it's a leader or a laggard.
  * **Standardization:** Ratios standardize financial information, allowing you to compare a massive company like Apple with a smaller competitor on an equal footing. It's not about the size of the profit, but the //quality// and //efficiency// of that profit generation.
===== The Investor's Toolkit: Key Ratio Categories =====
While there are dozens of ratios, they generally fall into a few key categories. Mastering a handful from each group will give you a powerful lens through which to view any company.
==== Liquidity Ratios: Can the Company Pay Its Bills? ====
These ratios measure a company's ability to meet its short-term obligations (debts due within one year). A company that can't pay its bills is a company in trouble, no matter how profitable it seems.
  * **[[Current Ratio]]:** Calculated as [[Current Assets]] / [[Current Liabilities]]. This is the most basic liquidity test. It answers: "For every dollar of debt due soon, how many dollars of short-term assets does the company have?" A ratio above 1 is generally considered safe, but context is key.
  * **[[Quick Ratio]] (or Acid-Test Ratio):** Calculated as ([[Current Assets]] - [[Inventory]]) / [[Current Liabilities]]. This is a stricter version of the current ratio. It removes inventory from the equation because selling products can sometimes take a while, especially during a downturn. It shows if a company can pay its bills without relying on selling its stock of goods.
==== Profitability Ratios: Is the Company Making Money? ====
This is the bottom line for most investors. These ratios measure how effectively a company is turning sales and assets into profits.
  * **[[Net Profit Margin]]:** Calculated as [[Net Income]] / Revenue. After all the bills are paid—salaries, materials, taxes, interest—what percentage of each dollar of revenue is left over as pure profit? A consistently high net profit margin is often a sign of a strong [[Competitive Advantage]].
  * **[[Return on Equity (ROE)]]:** Calculated as [[Net Income]] / [[Shareholder's Equity]]. This is a superstar ratio for value investors. It measures how much profit the company generates for every dollar of equity invested by its shareholders. A high and stable ROE suggests that management is excellent at deploying shareholder capital to grow the business.
==== Leverage (or Solvency) Ratios: How Much Debt Is Too Much? ====
These ratios examine how much a company relies on debt to finance its operations. While some debt can boost growth, too much can sink a company if its fortunes turn.
  * **[[Debt-to-Equity Ratio]]:** Calculated as Total Debt / [[Shareholder's Equity]]. This classic ratio compares what the company owes to what it owns. A high ratio (e.g., above 2.0) can be a red flag, indicating high risk, though what's "normal" varies wildly by industry.
  * **[[Interest Coverage Ratio]]:** Calculated as [[EBIT]] / Interest Expense. This measures a company's ability to make its interest payments from its operating profits. A ratio of 5x means earnings are five times greater than the interest bill, providing a healthy cushion. A ratio below 1.5x is a major warning sign.
==== Efficiency Ratios: How Well Is the Business Running? ====
Also known as Activity Ratios, these tell you how well a company is using its assets and managing its operations.
  * **[[Inventory Turnover]]:** Calculated as [[Cost of Goods Sold]] / Average Inventory. This shows how many times a company has sold and replaced its inventory over a period. A high turnover is generally good—it means products aren't sitting on shelves collecting dust.
  * **[[Asset Turnover Ratio]]:** Calculated as Revenue / Total Assets. This measures how efficiently a company uses its assets (factories, equipment, cash) to generate sales. It answers: "For every dollar of assets, how many dollars of revenue does the company create?"
===== The Art and Science of Ratio Analysis =====
Using ratios effectively is more art than a rigid science. The numbers are the starting point for your questions, not the final answer.
==== It's All About Context ====
A single ratio is meaningless without context.
  - **Compare across time:** Is the company’s [[Return on Equity (ROE)]] getting better or worse over the last 5-10 years? A positive trend is a great sign.
  - **Compare across the industry:** A tech company might have zero debt, while a capital-intensive utility company might have a [[Debt-to-Equity Ratio]] of 2.0. Neither is inherently "bad"; they must be judged against their industry peers.
==== A Word of Warning ====
Be a skeptic. Always remember:
  - **Accounting Gimmicks:** Clever accountants can legally manipulate financial statements to make ratios look better than they are. This is why you must read the footnotes in financial reports!
  - **One-Off Events:** The sale of a large division or a major lawsuit can skew the numbers for a single year. Always look at multi-year trends to smooth out these anomalies.
  - **No Magic Number:** There is no single "perfect" value for any ratio. Your job as an investor is to use these ratios to build a holistic, qualitative picture of the business and its management. Ratio analysis doesn't give you the answers, but it teaches you to ask the right questions.