From numbers to diagnosis

Ratios sort the symptoms

Two annual reports land on your desk the same morning. Kestrel Labs earned $20m on $100m of revenue. Redfern Grocers earned $30m on $300m. Your fund's partner wants to know by lunch which is the better business, and the honest answer starts with a division.

A ratio puts two related amounts in context. Kestrel's net margin is 20 ÷ 100 = 20%. Redfern's is 30 ÷ 300 = 10%. Redfern earns more in total; Kestrel earns more per sales dollar. Neither number says which you would rather own. Before you favor either, compare what they sell, how much capital each needs, how risky the earnings are, and where those earnings come from.

Ratios come in four families, and each family asks one question. Profitability ratios ask how much of the revenue, or of the resources, turns into earnings. Liquidity ratios ask whether short-term resources cover short-term obligations. Activity ratios ask how hard the assets work: sales per dollar of assets, days to collect an invoice. Leverage and coverage ratios ask how much is borrowed and whether earnings can carry the interest. No single ratio can establish that a business is healthy.

This unit sharpens the bridge question: how does one number become another? A ratio is the first step, because it forces you to say which two numbers you think are connected. Most ratios put a Scorecard flow over a Snapshot stock. Debt to EBITDA divides a debt balance on a date, from the Snapshot (balance sheet), by a year of earnings, from the Scorecard (income statement). Interest coverage usually divides EBIT by interest expense, two flows. The current ratio divides current assets by current liabilities, two stocks. State the definition, the period and whether the stock is an average, or two analysts will get two answers from one report.

Common-size statements divide every line by one base. Revenue for the Scorecard, total assets for the Snapshot. If Redfern's cost of sales moves from 70% of revenue to 74%, you see the cost structure shift without growth getting in the way. Common-size does not remove differences in framework, perimeter or valuation. An IFRS filer, a freshly carved-out division and a company that revalues its property still will not line up.

A ratio describes a pattern; it does not explain it. If receivable days worsen, inspect the credit terms and the collections queue. If margin improves, inspect price, mix, input costs and the accounting estimates. Read trends, peers and operating evidence together. The ratio tells you where to look; the evidence tells you what happened.