When an interviewer asks how you would assess a company, they want ratios, and they want you to say what each one tells you rather than just name it. This deck covers the handful that come up: the liquidity ratios that say whether a company can pay its bills, the leverage ratios that say how much debt it carries, the profitability ratios that say how good the business is, and the efficiency ratios that say how hard its assets work. Every one is explained from the statement it comes from, so you can rebuild it under pressure instead of remembering a formula.
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Card 1 of 16
What is a financial ratio, and why do analysts use ratios instead of the raw numbers?
A ratio turns two numbers into one that can be compared across companies, years and sizes.
A ratio divides one figure from the financial statements by another so the result means something on its own. Calder Foods making £40m of profit tells you little; £40m on £400m of sales, a 10% margin, tells you how good the business is, and lets you compare it with a rival ten times its size. Ratios strip out scale, so you can line a company up against its peers, against its own history, and against what a lender or investor expects. The skill is not calculating them, it is knowing which one answers the question being asked.
Card 2 of 16
What is the current ratio, and what does it tell you?
Current assets over current liabilities: whether the company can cover what it owes in the next year.
The current ratio is current assets divided by current liabilities, both from the balance sheet. Current assets are cash and things that turn into cash within a year, like receivables and inventory; current liabilities are what falls due in the same window. A ratio above one means the company could, in principle, pay everything due this year from what it has. Below one is a warning, though some businesses run there comfortably, like supermarkets that get paid in cash before they pay suppliers. A very high ratio can also mean cash or stock sitting idle.
Card 3 of 16
What is the quick ratio, and why would you use it instead of the current ratio?
The quick ratio drops inventory, because stock is the current asset that may not turn into cash when you need it.
The quick ratio, sometimes called the acid test, is current assets minus inventory, divided by current liabilities. It asks the same question as the current ratio but is stricter: if the company had to pay everything due this year without selling any stock, could it? Inventory is the current asset most likely to be worth less than the balance sheet says, or to sell slowly, which is why it is excluded. For Ferrow Retail, with warehouses full of seasonal clothing, the two ratios can differ a lot; for a software company with no stock they are the same.
Card 4 of 16
What is the debt-to-equity ratio, and what does a high number mean?
Total debt over shareholders' equity: how much of the company is funded by lenders rather than owners.
Debt to equity is total borrowings divided by shareholders' equity, both from the balance sheet. It shows how the company is financed. A ratio of 2 means lenders have put in twice what the owners have. Higher leverage magnifies returns to shareholders when things go well and losses when they do not, because interest has to be paid regardless. What counts as high depends on the industry: Redhill Utilities, with steady regulated cash flows, can carry far more than a fashion retailer whose sales swing with the season. Compare with peers, not against a universal number.
Card 5 of 16
What is net debt to EBITDA, and why do lenders prefer it to debt to equity?
Net debt over EBITDA says how many years of operating cash it would take to repay the debt.
Net debt is total borrowings minus cash. Dividing it by EBITDA, a rough measure of the cash the operations generate before interest, tax and non-cash charges, tells you how many years of that cash would clear the debt. A company at 2x could pay off its debt in about two years of earnings; at 6x it is heavily levered. Lenders like it because it compares debt with the thing that actually services debt, cash flow, rather than with equity, which is an accounting number that can be distorted by write-downs and buybacks. Loan agreements often set a maximum on it.
Card 6 of 16
What is interest cover, and what level starts to worry a lender?
EBIT over interest expense: how many times the company's operating profit covers its interest bill.
Interest cover is operating profit, EBIT, divided by the interest expense for the year. It answers a simple question: if profits fell, how far could they fall before the company could not pay its interest? Cover of 8x is comfortable; below 2x means a modest bad year could tip the company into default, and lenders will price the loan accordingly or refuse it. Bramwell & Co. reporting EBIT of £60m against £30m of interest has cover of 2x, and its bankers would be watching. Cover is the ratio that connects the income statement to the credit story.
Card 7 of 16
What are gross margin, operating margin and net margin, and why look at all three?
Each margin strips out one more layer of cost, so the gaps between them show where the money goes.
Gross margin is revenue minus the direct cost of what was sold, divided by revenue: what is left after making the product. Operating margin also takes off overheads like rent, salaries and marketing: what is left from running the business. Net margin takes off interest and tax too: what is left for shareholders. Looking at all three shows where a company is strong or weak. Calder Foods with a 45% gross margin but a 4% operating margin has a good product and a bloated cost base. A rival with 30% and 8% is worse at making things and better at running the company.
Card 8 of 16
What is return on equity, and why can a high ROE be a warning sign as well as a good one?
Net income over shareholders' equity: the return owners earn on their money, which leverage can flatter.
Return on equity is net income divided by shareholders' equity. It tells owners what they earn on what they have put in and left in the business. A steady 15% is good; 30% is exceptional. The catch is that borrowing raises it: if a company funds itself mostly with debt, the equity base is small, so even ordinary profits look like a big return on it. That is why a high ROE alongside a high debt-to-equity ratio is a lender's story, not a great-business story. Return on capital employed, which uses debt plus equity in the denominator, strips that effect out.
Card 9 of 16
What is return on capital employed, and why do many analysts prefer it to ROE?
EBIT over debt plus equity: how well the business uses all the money in it, whoever provided it.
Return on capital employed is operating profit divided by the total capital in the business, debt plus equity, or equivalently total assets minus current liabilities. Because it uses profit before interest and capital from all sources, it is not flattered by how the company is financed. Two companies with the same operations will show the same ROCE whether one borrowed heavily and the other did not, whereas their ROEs would differ. A ROCE well above the company's cost of capital means every pound invested in the business is creating value; below it, growth destroys value.
Card 10 of 16
What is asset turnover, and how does it explain why a supermarket and a luxury brand can earn the same return?
Revenue over total assets: how many pounds of sales each pound of assets produces.
Asset turnover is revenue divided by total assets. It measures how hard the assets work. A supermarket has a low margin but turns its assets many times a year, because stock flies off the shelves; a luxury watchmaker turns its assets slowly but earns a huge margin on each sale. Multiply margin by turnover and you get return on assets, so two very different businesses can arrive at the same return by different routes. That decomposition, called DuPont analysis, is a favourite interview question because it shows whether you understand what drives returns rather than just naming them.
Card 11 of 16
What are receivable days, inventory days and payable days, and what does the working capital cycle tell you?
How long the company waits to be paid, holds stock, and takes to pay suppliers, and therefore how much cash is tied up.
Receivable days is receivables divided by revenue, times 365: how long customers take to pay. Inventory days is inventory over cost of sales, times 365: how long stock sits before it sells. Payable days is payables over cost of sales, times 365: how long the company takes to pay suppliers. Add the first two and subtract the third and you get the cash conversion cycle, the number of days the company's own cash is tied up. Northbay Logistics with 60 receivable days and 30 payable days is lending its customers a month of cash. Shortening the cycle frees cash without any change in profit.
Card 12 of 16
What is earnings per share, and why does a company's EPS matter more to the share price than its total profit?
Net income divided by shares outstanding: the profit that belongs to each share, which is what a shareholder actually owns.
Earnings per share is net income divided by the number of shares. A shareholder does not own the company's profit, she owns a share of it, so the number that matters to her is profit per share. It is why a company can grow profit and still see its share price fall: if it issued lots of new shares to do it, each share's slice shrank. It is also why buybacks lift the share price, since fewer shares means more profit per share. Diluted EPS also counts shares that could exist from options and convertibles, and is the more honest figure.
Card 13 of 16
What is the price-to-earnings ratio, and what does a high one actually tell you?
Share price over EPS: how many years of current earnings the market is paying for, which reflects expected growth.
The P/E ratio is the share price divided by earnings per share, or equivalently market capitalisation over net income. At 15x, investors are paying £15 for every £1 of this year's profit. A high P/E does not mean a share is expensive so much as that the market expects earnings to grow fast; a low one means it expects little growth, or sees risk. Comparing P/Es only makes sense between similar companies. The ratio also breaks when earnings are near zero or negative, which is why analysts fall back on EV/EBITDA for loss-making or heavily indebted companies.
Card 14 of 16
What is dividend yield, and what is the payout ratio?
Yield is the dividend as a percentage of the share price; payout is the dividend as a share of profit.
Dividend yield is the annual dividend per share divided by the share price. It tells an investor the cash return they get for holding the share, like interest on a bond. The payout ratio is dividends divided by net income, the share of profit paid out rather than reinvested. A high yield with a payout ratio above 100% means the company is paying more than it earns, which cannot last, and the market is usually pricing in a cut. Redhill Utilities paying out 70% of steady earnings is normal; a growth company paying nothing and reinvesting everything is normal too.
Card 15 of 16
Ferrow Retail has a current ratio of 0.8, net debt to EBITDA of 4.5x and interest cover of 1.8x. What is the picture, and what would you ask next?
Tight liquidity, heavy leverage and thin cover together say the company is one bad season from trouble.
Each number alone could be explained away: retailers often run current ratios below one, and 4.5x leverage is high but survivable for a stable business. Together they tell one story. Ferrow owes more this year than it has coming in, carries four and a half years of earnings in debt, and has less than two pounds of operating profit for every pound of interest. A weak Christmas would push cover below one. The questions to ask next are when the debt matures, whether the loans have covenants tied to these ratios, and how much of the current liabilities is trade credit that can be stretched.
Card 16 of 16
An interviewer asks how you would compare Calder Foods with a listed rival using ratios. How do you structure the answer?
Pick one ratio from each family, compare against the peer and against the company's own history, and say what the differences mean.
Go family by family so you never freeze. Profitability: gross and operating margin, to see which company has the better product and the leaner cost base. Returns: ROCE, to see which one turns capital into profit more efficiently. Leverage: net debt to EBITDA and interest cover, to see which balance sheet is safer. Liquidity: current or quick ratio. Efficiency: inventory and receivable days, to see who runs tighter. For each, say the number, say what it means, and say why it might differ, since a lower margin could be a worse business or a deliberately cheaper strategy. That is the whole answer.
Reading is not the same as remembering. Study this deck with scheduled review so the cards come back before you forget them.