How does ratio analysis inform investment decisions?

Ratio analysis translates a company's raw financial statements into structured indicators that investors use to judge performance, risk, and value. By comparing measures such as margins, returns, liquidity, and leverage, analysts compress complex accounting data into tractable signals. Aswath Damodaran at New York University Stern School of Business emphasizes that ratios are not ends in themselves but tools for comparing firms across time and against peers, helping investors form expectations about cash flows, required returns, and downside exposures.

Key ratios and what they reveal
Profitability ratios like return on equity and net profit margin show how effectively management converts sales and invested capital into earnings. Liquidity ratios such as the current ratio and quick ratio indicate short-term solvency and the ability to meet obligations during stress. Leverage ratios, including debt-to-equity and interest coverage, illuminate financial risk and the potential amplification of returns or losses. Valuation ratios like price-to-earnings and enterprise-value-to-EBITDA link reported earnings to market prices, guiding buy, hold, or sell decisions. Benjamin Graham at Columbia Business School established the foundational idea that conservative use of these metrics, especially valuation and margin of safety, reduces downside risk for investors focused on intrinsic value.

Contextual adjustments and comparability
Raw ratios must be interpreted in context. Industry structure, growth stage, and accounting policies can drive wide differences that do not reflect managerial skill. Differences in recognition rules promulgated by the Financial Accounting Standards Board in the United States and the International Accounting Standards Board globally can change relevant numerator or denominator figures, reducing cross-border comparability. Seasonal revenue patterns, one-time gains or losses, and currency effects can make single-period ratios misleading. Analysts often normalize earnings and adjust for nonrecurring items to uncover sustainable performance.

Causes, consequences, and broader considerations
The causes of ratio movements include operational shifts, changes in capital structure, and accounting choices. A rising leverage ratio may reflect deliberate debt-financed expansion or deteriorating margins forcing additional borrowing. Consequences for investors depend on the underlying cause: prudent leverage tied to profitable investment can increase returns, while leverage driven by declining cash flow raises default risk. Misreading ratios can lead to overpaying for growth, underestimating systemic exposure, or misallocating capital across sectors.

Human, cultural, and environmental dimensions matter. Corporate governance norms and cultural attitudes toward debt influence leverage norms across territories. Robert G. Eccles at Harvard Business School highlights that environmental, social, and governance disclosures increasingly affect traditional ratios because asset valuations and future cash-flow projections must incorporate climate risk and regulatory shifts. For example, firms in environmentally sensitive industries may face impairment risk that erodes book values and alters solvency ratios. Investors who integrate ratio analysis with qualitative assessment of governance, regulatory environment, and sustainability practices gain a more durable basis for decisions, reducing the chance that apparent value will prove illusory.