Managerial and Financial Analysis: Ratios, Interpretation and Decision Analysis
Ratio families
Build ratios in four groups: liquidity (current, quick, cash), efficiency (inventory days, receivable days, payable days, asset turnover), gearing (debt to equity, interest cover) and profitability (gross margin, net margin, ROCE, ROE). Interpret them together: a high current ratio may signal slow-moving inventory rather than strength.
Analytical techniques
Use trend analysis, common-size statements (each item as a percentage of revenue or total assets) and the DuPont decomposition. Cash flow analysis judges the quality of earnings by comparing operating cash flow with profit. At the managerial level, expect CVP, relevant costing, make-or-buy, limiting factors and other short-term decisions.
Traps
- Check whether a ratio uses closing or average balances, and stay consistent.
- Margin uses revenue as the base, mark-up uses cost: a 25% mark-up equals a 20% margin.
- ROCE uses operating profit and capital employed (equity plus non-current liabilities), not net profit.
- Window dressing such as year-end credit tightening can flatter liquidity ratios.
- Ratios ignore accounting policy differences, inflation and off-balance-sheet arrangements; they are a starting point, not a conclusion.
Worked example
Net profit margin 8%, asset turnover 1.5 times, equity multiplier 2.0, so ROE = 8% x 1.5 x 2.0 = 24%. Management can raise ROE by improving margin, working assets harder, or increasing gearing; the last option also raises financial risk, which interest cover will reveal.