FOUNDATION 05 / Business & data
Business ratios & interpretation
Calculate a few useful ratios, then ask why they changed and whether comparisons are fair.
By the end of this lesson
- Calculate liquidity, margin, turnover and return measures.
- Use average balances when comparing flows and stocks.
- Explain why a high ratio is not automatically good.
IBBC Capital Finance Foundations · Original content drafted with AI assistance. IBBC Capital is responsible for editorial review and content. General education, not an official CFA Institute curriculum or credential.
Start with a business question
Liquidity asks whether near-term obligations can be met; profitability asks what earnings are produced; efficiency asks how resources are used; leverage asks how claims are financed. Choose a ratio to answer a question rather than collecting numbers without purpose.
Current ratio = current assets/current liabilities. It uses accounting classifications, not an assessment of how quickly every asset can become cash. Old inventory or disputed receivables may weaken apparent liquidity.
Profitability and resource use
Net margin = net income/revenue. Asset turnover = revenue/average assets. A simplified ROA = net income/average assets, so ROA = margin×turnover when the definitions match. Average assets here means (opening+closing)/2.
Definitions differ across analysts; some adjust income or use more frequent balances. State your convention. A retailer with thin margins may still earn an adequate return through fast turnover.
Leverage amplifies both directions
A simplified ROE decomposition is margin×asset turnover×(average assets/average equity). Holding other factors constant, a larger equity multiplier can raise ROE while increasing financial risk. Higher ROE alone does not establish better operating quality.
Negative or very small equity can make ROE hard to interpret. Separate debt service obligations, maturities and covenants from a headline leverage ratio. A ratio cannot replace a cash-flow forecast.
Compare like with like
Compare trends and relevant peers with similar periods, accounting choices and business models. Remove or at least flag one-off items. Seasonal balance-sheet dates can distort a simple opening/closing average.
Write one observation, one possible explanation and one piece of evidence needed. Example: margin fell; input costs may have risen; verify with cost disclosures. This separates analysis from unsupported certainty.
A compact business snapshot
- Revenue 1,000, net income 100, opening assets 400, closing assets 600.
- Average assets = 500; net margin = 10%; turnover = 2.0×.
- Simplified ROA = 100/500 = 20% = 10%×2.
- If current assets are 240 and current liabilities 120, current ratio = 2.0×; asset quality still needs review.
Try before looking at the explanation
Change one input in the practice tool below. Predict the direction first, calculate second, then explain why it changed.
Work the numbers
Common mistakes to catch
- Mixing quarterly revenue with annual income.
- Using closing assets without disclosing the convention.
- Calling higher leverage an improvement without considering risk.
Knowledge check · 6 original questions
Answer all six. At least five correct marks the lesson complete for self-study. You can retry; this is not a credential.
Keep these ideas
- Ratios organize questions; context gives them meaning.
- Use consistent definitions and disclose limitations.