Ratio analysis

Definition

Ratio analysis normalizes statement lines against each other so businesses can be compared across size and time: profitability (margins, returns on capital), efficiency (turnover ratios), leverage (debt service and structure), and liquidity (near-term coverage). Ratios are the fundamental lens’s measurement units — and the platform’s rule is that a ratio is only meaningful against a BENCHMARK (its own history, its sector, or an economic hurdle), never as a bare number.

How it works / structure

• Profitability: gross/operating/net margins (the cascade locates the economics); ROE decomposed by DuPont into margin × turnover × leverage — the decomposition matters because a leverage-driven ROE is a different risk than a margin-driven one; ROIC vs cost of capital (the value-creation hurdle — fa-capital-allocation).
• Efficiency: asset/inventory/receivables turnover; the cash conversion cycle (days inventory + days receivable − days payable) — deterioration here leads earnings trouble (fa-earnings-quality accrual link).
• Leverage & liquidity: net debt/EBITDA, interest coverage, current ratio, and the maturity schedule; covenant proximity is a regime-changer for equity risk.
• Engine-executable form: each ratio with its statement sources pinned (GAAP lines, not adjusted), trend windows, and benchmark set (sector percentile, own-history z-score) — fa-sector-metrics supplies the sector-specific overrides where standard ratios mislead.

When it applies

Screening (the quantitative expression of fundamental hypotheses — Piotroski’s F-Score is the documented example: nine binary statement signals that separated winners within value stocks in his sample); thesis measurement (a margin- expansion thesis IS a ratio path); credit-risk context for equity and options positions.

Risk profile & failure modes

• Cross-sector nonsense: comparing a bank’s leverage to a utility’s, or a SaaS gross margin to a grocer’s — sector norms differ structurally (fa-sector-metrics exists for this).
• Accounting-choice contamination: leases, pensions, and capitalization choices move ratios without moving economics; restated comparisons need consistent treatments.
• Snapshot gaming: quarter-end ratios are managed; trends and averages resist it better.
• Screen crowding: published ratio screens (F-Score included) decay post-publication like every documented signal (lens-quantitative).

Evidence & limits

Ratio construction is accounting arithmetic. Piotroski (2000) is the canonical evidence that statement-derived ratios carried return information (within his value-stock sample and period); the factor literature (strategy-factor-investing profitability/quality factors) is the systematic descendant. All return claims are sample-bound and decay-suspect; the measurement function is permanent.

Falsifiable-thesis examples

Illustrations only, not signals:

• “X’s operating margin will expand at least 100bp year-over- year in two of the next four quarters (operating-leverage thesis)” — falsified by the filed cascade.
• “The top F-Score tercile of sector S will outperform its bottom tercile over the next year” — falsified by the cohort returns.

Cross-references

• Input layer: fa-financial-statements; sector overrides: fa-sector-metrics
• Quality interaction: fa-earnings-quality (accrual ratios)
• Valuation bridge: fa-multiples-comparables, fa-dcf-valuation
• Systematic descendant: strategy-factor-investing