Ratio Analysis
Ratio Analysis
Start with a question
Northstar’s revenue rose. Did growth improve margins, use assets efficiently, convert into cash and remain financeable?
Condensed data, £000
| 2025 | 2026 | |
|---|---|---|
| Revenue | 500 | 600 |
| Gross profit | 210 | 240 |
| Operating profit | 70 | 90 |
| Net income | 47 | 60 |
| Operating cash flow | — | 65 |
| Current assets | 190 | 250 |
| Current liabilities | 105 | 125 |
| Cash | 45 | 60 |
| Receivables | 65 | 90 |
| Inventory | 80 | 100 |
| Trade payables | 65 | 80 |
| Total assets | 400 | 530 |
| Debt | 120 | 160 |
| Equity | 150 | 200 |
2026 purchases are £380,000: cost of sales £360,000 + closing inventory £100,000 − opening inventory £80,000. Capital expenditure is £80,000.
1. Profitability: locate the layer
| Ratio | 2025 | 2026 | Initial reading |
|---|---|---|---|
| Gross margin | 42.0% | 40.0% | Product/input economics weakened by 2 points |
| Operating margin | 14.0% | 15.0% | Other operating costs grew slower than revenue |
| Net margin | 9.4% | 10.0% | Financing and tax did not erase the operating gain |
Do not stop at “margin improved.” Gross margin fell while operating margin rose. Investigate price, mix, component costs, production efficiency and operating-cost scale separately.
2. Liquidity: inspect composition
| Ratio | 2025 | 2026 |
|---|---|---|
| Current ratio | 190 / 105 = 1.81 | 250 / 125 = 2.00 |
| Quick ratio | (45 + 65) / 105 = 1.05 | (60 + 90) / 125 = 1.20 |
There is no universal “healthy 2:1.” A supermarket and a project contractor have different working-capital cycles. Check aging, inventory saleability, seasonality, unused facilities and liability timing.
3. Working-capital cycle: use the right flow
Using averages for 2026 and total sales as a disclosed proxy because credit-sales data is unavailable:
| Measure | Calculation | Days |
|---|---|---|
| DIO | 365 × average inventory £90 / cost of sales £360 | 91.3 |
| DSO | 365 × average receivables £77.5 / sales £600 | 47.1 |
| DPO | 365 × average payables £72.5 / purchases £380 | 69.6 |
| Cash conversion cycle | DIO + DSO − DPO | 68.8 |
Use credit sales for DSO and credit purchases for DPO when available. Total sales and cost of sales are proxies, not automatically correct denominators.
The 68.8 days has no trend because 2024 opening balances were not supplied. A disciplined analyst says “current estimate,” not “deteriorated.”
4. Returns: decompose ROE
Using average assets of £465 and average equity of £175:
ROE combines operations and financing. A higher equity multiplier can lift ROE while also increasing risk.
5. Cash cross-check
- Operating cash flow / net income = 65 / 60 = 1.08.
- A common management-defined free-cash-flow proxy is CFO − capex = 65 − 80 = −£15,000.
Neither result is self-interpreting:
- CFO can exceed profit because of depreciation or temporary working-capital movements.
- Negative free cash flow can indicate growth investment or distress.
- “Free cash flow” is not a single IFRS/US GAAP subtotal; define and reconcile it.
Recalculate and stress-test
Northstar ratio and cash-cycle audit
Real-report check
Unilever’s 2025 Annual Report reported turnover down 3.8% while underlying sales growth was positive, with currency and portfolio effects explaining much of the difference. This is a useful lesson:
- reported growth and management-defined growth answer different questions;
- a non-GAAP measure requires definition and reconciliation;
- volume, price, currency and disposals should not be collapsed into one label.
Research also warns against one universal earnings-quality proxy. Dechow, Ge and Schrand’s review concludes that quality depends on the decision context; Sloan’s accrual study motivates separating cash and accrual components rather than blindly “trusting cash.”
A five-sentence analysis template
- State the movement and comparison.
- Decompose the numerator and denominator.
- Link the movement to an operational hypothesis.
- Cross-check cash, notes and accounting policy.
- State missing evidence and the next test.
Quick check
Can you conclude that Northstar collected customers more slowly in 2026 because DSO is 47.1 days?