BUSI 170 - Financial Analysis for Leaders (Section 5.2)
August 19, 2026
Financial statements are reports, and a lot of people think that these are used directly. It turns out that the pros treat this as the raw data from which to create informative analyses. I am going to teach you how to do that.
There are dozens of ratios and you do not need to memorize them. What you need is to know which question each family of ratios answers. There are four questions, and we will take them one at a time.
Here is a question students ask me. Why do we have all these subtotals? Why do we not just talk about the bottom line? Isn’t that the final result?
Think about a track athlete running the 1600 meters. That is four times around the track. When runners train for this race it is common to record splits, the times it takes to run each of the four laps. Why do that? Because runners want to know where they are losing or gaining pace. It helps them understand their overall performance by breaking it down, lap by lap.
The income statement does the same thing with its intermediate profit numbers. Separating things into gross profit, then operating profit, helps us see how performance changes as we break the business up into its parts.
Gross profit tells us what we make after covering the cost of the products we sold. It is the first indicator of profitability, and it focuses only on the cost of goods and sales revenue.
\[\text{Gross margin} = \frac{\text{Revenue} - \text{COGS}}{\text{Revenue}}\]
If we are performing poorly at the gross margin level, that focuses us on looking harder at product costs.
Travel further down the income statement and we see operating profit. Operating profit starts with gross profit, then subtracts the additional expenses that are used to run the business.
\[\text{Operating margin} = \frac{\text{Operating profit}}{\text{Revenue}}\]
If we have great gross profits but lousy operating profits, that tells us something specific: we are making profitable products, but the cost of selling them is hurting our profitability.
Net profit is at the bottom. The expression “the bottom line” comes from accounting, and it means the final result after all things are taken into account. From operating income we might have other activities, other income or expense that is not core to the business. We also have to take income tax into account, and that is the last thing subtracted before the bottom line.
\[\text{Net margin} = \frac{\text{Net profit}}{\text{Revenue}}\]
Things like taxes and non-recurring income are things managers have little control over, or things that are not representative of how the business performs year after year. That is why it can be useful to separate them out.
Up until now, all these measures of profit come right off the income statement. But it is useful to think about profits or returns in relation to assets. We invest in assets to generate profits, so it makes sense that we want to know how much profit we are making for every dollar of assets we have.
\[\text{ROA} = \frac{\text{Net profit}}{\text{Total assets}}\]
Return on assets is a ratio that shows how well you are turning your total assets into profits. It is about getting the most from what you own.
Another ratio that combines accounts from the income statement and the balance sheet is return on equity. It is similar to return on assets, but instead of calculating how much profit we are making for each dollar invested in assets, we are looking at how much profit we are generating for each dollar the business owners are investing.
\[\text{ROE} = \frac{\text{Net profit}}{\text{Owners' equity}}\]
Each step here is like a subtotal on a journey of figuring out where we are making money, or not making money, at each step. Is it at the product? Is it in supplying the product? Is it in making the product or service? Is it the business of getting that product or service delivered to customers? Is it financing? And finally, the government.
Each one of these profitability numbers tells us a story about how this business makes money, and helps us diagnose how we can improve it.
If you are looking to get into business or to grow one, the day will come when you need to get some funding, either to start something up or to grow operations. When you go borrowing money, what are lenders looking for? Will you get the money? And what will you need to show in order to get it?
That is what leverage ratios are for. They tell us how much debt a company uses to finance its assets.
Who wants to know this? This is about creditworthiness. If you are a bank, or a business thinking of loaning out some money to another, these metrics give you the insight on whether or not to make the loan. And if you are on the other side of the table, if you are a business looking to borrow, you should know that these are the metrics others are using to evaluate you, to figure out whether your business is a good venture.
Consider the debt-to-equity ratio. It is calculated by dividing total liabilities by shareholders’ equity.
\[\text{Debt-to-equity} = \frac{\text{Total liabilities}}{\text{Owners' equity}}\]
Say you have three hundred thousand dollars in assets, financed by two hundred thousand in debt and one hundred thousand in equity. The debt-to-equity ratio would be 2. This means the company uses twice as much debt as equity to finance its operations.
High leverage can mean higher risk, but also higher potential returns. Why? Because the owners are using other people’s money to grow the size of the business. This is what we mean by financial leverage.
There is another way of thinking about creditworthiness. Do you make enough money to meet your interest payments? Here we look at the interest coverage ratio, which measures a company’s ability to handle its debt obligations with its earnings before interest and taxes.
\[\text{Interest coverage} = \frac{\text{EBIT}}{\text{Interest expense}}\]
Say you have a company with profits of fifty thousand and interest expense of ten thousand. Our interest coverage ratio is 5. That indicates a position to cover debt costs five fold.
So how much debt is too much? What should our debt ratios be? Obviously we think too much debt is not good, but what is too much?
This all depends on the industry, and a lot of it depends on how predictable the business is. If you absolutely knew - if you had a crystal ball for exactly how much you were going to make - what you could do is take a lot of debt and use other people’s money, because you know what you are going to accomplish. If you have things locked in, contracts about exactly what you were going to make, you would be very comfortable taking a lot of debt.
The problem is if you are not sure what it is going to be. It can be really high or really low. If you take on a lot of debt and then your business is just not that profitable, or there is just not that much activity, you suddenly have all this money to pay back and no means to do it.
What you find is that people who understand their business very well, where the cycle is very predictable and we know what the outcomes are going to be, it makes sense for them to have more debt, because it is stable. You can count on the money coming in and you can use other people’s money to grow really big. If you do not know what is going on and you are not really sure, and the future is uncertain, that can be very costly, because the mistakes can be really high if you predict wrong.
At the same time, you could have too little debt. If it is very predictable and you are not taking out debt, what are you giving up? You could have taken on some more debt to finance growing bigger, and as you grow bigger you become more efficient, more profitable - but you decided to grow slower, or not to grow at all, because you were too allergic to getting that debt.
Understanding leverage ratios is not just about the numbers you compute. It is about understanding the story behind those numbers, and the implications behind them.
So who cares about leverage ratios? Primarily the people who are going to be your creditors - banks. They want to know that if they give you money, what you are using it for. They want to know that there is safety in them getting paid back. Managers also want to understand the leverage ratios, because risk on leverage is risk to their business. It can be very distracting.
Liquidity ratios show us how well a company can meet its short-term obligations. As an indicator of financial health this is similar to leverage ratios, and the difference is time. Leverage ratios are about long-term structure: is your mix of debt and equity in a healthy spot to operate from? Liquidity ratios are much more near term. Do you have the free cash in the short term to keep the doors open and the business running?
Take the current ratio. It is calculated by dividing current assets by current liabilities.
\[\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}\]
Say we have a business with one hundred and fifty thousand in current assets and seventy-five thousand in current liabilities. The current ratio is 2, indicating the company can comfortably cover its short-term debts twice over. That is a sign of good liquidity.
Then there is the quick ratio. It is similar but it excludes inventory from current assets, which makes it a stricter measure of liquidity.
\[\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}\]
If we had, say, fifty thousand of those current assets in inventory, after taking this out our quick ratio is 1.33. Still a healthy sign, but more conservative than the current ratio.
Why might we want to exclude inventory? We are likely going to turn inventory into cash soon, but it is not cash yet, and we cannot pay our bills in inventory. Say we came upon hard times and we had to come up with cash quickly. We could only access cash to make payments. If we had to turn inventory into cash quickly, we might have to discount it a lot just to move it.
It is worth saying that it is also not good to have too high a current ratio. That would mean you have lots of current assets lying around that are not really being used. Cash is nice to have, but having a lot on hand means that you are not putting it to work to generate more value in the business.
If you have got a lot of cash lying around, what is that for, if you are not investing in the business? Why not take it out and give it back to your shareholders, or take a really nice vacation, or spend it on something you want? Or, if you have investors, let them have that cash back so they can invest in other things. Cash is really important, and it is also an unproductive asset. Cash lying around does not help you make more cash, so if you have too much lying around, that is also bad for the business.
You want to know this as an investor. Who else wants to know? Anyone the business connects with. Suppliers want to know they can count on this customer to be around to pay bills and be a partner into the future. Employees want to know that their jobs are safe. Even communities want to know which businesses are fragile and which businesses they can count on.
Here is a typical problem. Let us say you are growing, and that means more profits, which is great. But you are also finding that you need to get more money from the bank just to keep the business running. Money for running the day-to-day is called working capital. And let us say your need for working capital is outpacing your growing profits.
It feels weird. Why are you short of cash when you are growing profits?
If you find yourself in this bind, it is a problem of efficiency. As you grew, you became less efficient. This happens a lot. As a business grows, inventory management gets more sloppy, leading to slower sales from stocked items. Sales are going crazy and we need to keep things in stock, but there are so many new items to sell that it is hard to track what to focus on.
Efficiency ratios help us understand how much we are making relative to what we had to put in. What is the activity, the output, versus what we had to commit? In business it is not just about what the costs were that we had to incur in order to generate the revenues - that is one way of talking about profitability. Efficiency is about what assets we had to put in place to get that profit in the first place. If we are going to invest in an asset and spend money to have it, how much value are we generating with it?
Here is one way to see it. Imagine you had a massive warehouse, and you had to spend millions of dollars stocking it, and then one person came in and bought one sweater. That one sweater would give you some profit, but you had to hold all that inventory to get it. That is super inefficient. It is locking up a lot of money, and perhaps all the money you had to invest in it is not worth making that one sale.
Now imagine somebody who has a really small food cart, selling donuts. They do not even have enough room on the cart for more than about 25 donuts, but it is really popular, and they have got a really efficient runner who keeps restocking them every time they sell out. Over a couple of square feet of sidewalk, they are selling tons of donuts out of this very small cart. They are getting lots of sales on a very small, efficient base, because they are able to replenish so fast.
That is the opposite story, and what it is measuring is turnover. How many donuts are we selling out of that really small food cart, versus a really big warehouse that only sold a few things? The warehouse has very low turnover.
\[\text{Inventory turnover} = \frac{\text{COGS}}{\text{Average inventory}}\]
This shows the number of times per year that the business sells off all of its inventory. That is a conceptual thing. A good business does not sell off all of its inventory at once. It is just an idea: imagine you had a little shop, filled it full of inventory, then sold it all, then refilled it again, over and over. How many times could you do that in a year? More turns suggests you are really efficient, getting lots of turns of sales in your small store. If you do not turn over things frequently, what do we see? You would see things lingering on the shelves for a longer time.
We can use inventory turnover to estimate the average time things are sitting on the shelf.
\[\text{DIO} = \frac{360}{\text{Inventory turnover}}\]
If you have turnover of 10 times per year, you can calculate about how long things stay on the shelf by taking the number of days in a year and dividing by turnover. This gives you days inventory outstanding, which is about how long things stay on the shelf.
You will notice that we sometimes use 360 days, and there are obviously 365 or 366 days in a year. Why do we have these different conventions? They are used almost interchangeably in accounting, because there was a time when we were making these calculations by hand and 360 was just close enough, and a round number to use. If you find in a lot of these calculations that you are using one or the other, it does not change the outcome very much. You are going to see different conventions about whether we are using 360 or 365 days. In general it should just be the approximate number of days in a year, to help us get a sense of these ratios.
In a drug store there are some things that move really quickly. Some kind of perishable food is moving very quickly and we replenish it very quickly, and a box of dental floss is stable and can stay a really long time, perhaps months. Different things are going to stay for different times, but this gives you a sense of about how long the average product spends on the shelf. It is a great measure of efficiency.
In business you want to make that time short, since that means your business is humming along at a good clip. When good operators see turnover decreasing, or days inventory outstanding creeping up, that is an indication that we need to focus on inventory management. How can we do that? By prioritizing best-sellers and negotiating better terms with suppliers. We can also use sales data for smarter ordering.
In addition to efficient use of capital, there is another reason why quick turns on inventory are better than slow turns. When you are holding stuff to sell, time is not on your side. More time means more time for inventory to get damaged, stolen, spoil, or become obsolete. We want to turn inventory into sales and cash as soon as we can.
Measuring turnover comes from the idea of thinking about your business as a cycle or a process. If you are a retail business, you sell goods that are made by other businesses. Your cycle looks like this. You buy some goods with cash, then you put that inventory on display. Some customer comes along and buys it, perhaps on credit. Then you have to collect that cash from the customer, and with that cash you will be ready to buy more goods to display. If you are in the retail business you want to turn that cycle as many times as you can in a given year or in a given space, because that means you are generating more value for that given investment.
Let us apply the turnover concept to accounts receivable. Accounts receivable is what our customers buy from us on credit. Winning here is about collecting on those receivables quickly, so we can turn credit sales into cash.
\[\text{Receivables turnover} = \frac{\text{Revenue}}{\text{Average accounts receivable}}\]
What does this tell us? It tells us that in a period of sales, how many times do we turn through our accounts receivable on the balance sheet? If we had a very small amount in average accounts receivable and sold a very large volume of stuff, it means we had many quick cycles of selling on credit and then collecting quickly. If this ratio is small, it means we are slow to collect. We make the sale and post the accounts receivable, but it takes us more time to collect on it. That means our business has to wait longer to get that cash from the sale.
\[\text{DSO} = \frac{360}{\text{Receivables turnover}}\]
Getting cash to us faster through faster collections helps bring money into the business quickly, which means more money to buy more goods and start this cycle over again.
There is another benefit of quick turns. When receivables are taking a long time to collect, it can be a sign that our customers might not be able to pay. Every day without cash collection makes it a bit more of a risk that they might not pay us at all. By speeding up collections, we lower that risk of bad debts.
We can do the same turnover metric with our debts to our suppliers, our accounts payable. Days payables outstanding tells us how long it takes us to pay our suppliers.
\[\text{Payables turnover} = \frac{\text{COGS}}{\text{Average accounts payable}} \qquad\qquad \text{DPO} = \frac{360}{\text{Payables turnover}}\]
Now that you know days inventory outstanding, days sales outstanding, and days payables outstanding, I can introduce you to the cash conversion cycle. We have examined each of these three business cycles in isolation. Did you know you can put this all together to get an insightful perspective on your business as a whole?
If you think about it, your business, no matter what service or product it provides, is like a money machine. We put money into it, and then it creates money, hopefully more, coming out the other end. We put cash in, and we get cash out.
If you buy and sell inventory, you need to take your money now, buy stuff, put it on the shelves, then wait. For customers to buy it, then wait. For customers who paid on credit to pay you back. And your suppliers have to wait, for you to pay them.
All the time you are waiting for customers to buy or to pay you back, you are out cash. All the time your suppliers are waiting for you, you have cash. The total time you are out of cash is days inventory outstanding plus days sales outstanding, minus days payables outstanding.
\[\text{Cash conversion cycle} = \text{DIO} + \text{DSO} - \text{DPO}\]
This metric tells us how long we are out of cash. The faster we move inventory and collect, the faster our cycle. We can also improve our cycle by taking a slower pace to pay our suppliers. In total, improving our cash conversion cycle is about using cash efficiently, using as little cash as possible to support the business we have.
You need working capital to make money. The cash conversion cycle makes two things clear. First, it tells you how many days worth of cash you need to put into the business to make it run. Second, it shows that the faster you turn the cycles, the less cash you need to operate.
You might be asking, what is a good number to have here? It is all relative.
How do you figure this out? Compare it to what is common in the industry. What have you done in the business over time? Can we justify a good reason for it, if it is a little bit different?
You will want to compare these ratios to other companies that are in the same industry, that are perhaps also similar in size. You can also make relevant comparisons of the same business over time. Have these measures improved or deteriorated over time? These comparisons put such ratios in context, and help you understand their relevance.
Later on we are going to take all of this into a concrete, comprehensive example and walk through exactly what it means. We will compare it against a real set of financial statements, with real numbers, and really draw out the insights. When we sit down with a real business, we will get into the specifics and down to the applications.
© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.