What is ratio analysis in financial modeling?
In the world of mergers and acquisitions (M&A), financial ratio analysis plays a crucial role in assessing a business's health, profitability, and potential for growth. As someone who's spent over six years in M&A and built more than 40 financial models, I’ve witnessed firsthand how these ratios can unlock the deeper stories behind the numbers. Today, let’s break down the essentials of financial ratio analysis, with a focus on how it helps assess revenue, profitability, working capital, capital structure, and more.
Revenue Analysis: Understanding Growth and Its Drivers
When you analyze revenue, it’s vital to dive deeper than just the numbers. Ask yourself: What’s driving revenue growth? Is it the volume of products sold or the pricing strategy?
Key Ratios: Compound Annual Growth Rate (CAGR), Year-over-Year (YoY) growth in price and volume
Core Insights: Breakdown revenue by product line, market, or distribution channel to understand which areas are contributing most to growth. Differentiating between organic growth and acquisitions is also critical—organic growth often signals a strong core business, while acquisitions could indicate a more aggressive strategy.
For example, in one of my M&A deals, we noticed that revenue growth was highly dependent on a few large clients. While the business showed overall revenue growth, there was significant risk tied to losing any of those clients. A deeper revenue analysis revealed where diversification was necessary.
COGS and Gross Margin Analysis: Unpacking Profitability
When assessing profitability, understanding your Cost of Goods Sold (COGS) is crucial. Are costs rising with sales, or is there inefficiency lurking within your production or service delivery?
Key Ratios: Gross Margin (GM) as % of revenue, GM per unit of volume
Core Insights: Differentiate between fixed and variable costs within COGS. Variable costs can be more easily adjusted as demand fluctuates, whereas fixed costs often don’t move with volume.
In one acquisition case, I found that while the company had a strong gross margin, their variable COGS were rising disproportionately due to inefficiencies in the supply chain. This pointed to potential cost-cutting measures that could significantly improve profitability post-acquisition.
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Operating Costs: Keeping an Eye on Personnel and Other Expenses
Another key area to focus on is personnel costs. How much of the company’s revenue is allocated to personnel, and what are the trends?
Key Ratios: Personnel costs as % of revenue, revenues per FTE (Full-Time Equivalent), and YoY growth in operating costs like marketing and distribution
Core Insights: Monitor operating costs such as wages, marketing expenses, and distribution costs. If wages are increasing faster than revenue, there may be efficiency issues. Similarly, high marketing spend might indicate either a need for better targeting or over-reliance on aggressive campaigns.
For example, in a recent M&A transaction, we found that the company’s personnel costs were climbing faster than revenue. This was due to rising salaries without corresponding productivity increases—something we identified as a potential red flag in our valuation.
Capex and Working Capital: Investment and Liquidity Health
When evaluating capital expenditures (Capex) and working capital, it’s important to distinguish between maintenance Capex (needed to sustain operations) and growth Capex (used for expansion).
Key Ratios: Capex as % of revenue, fixed asset turnover, working capital as % of revenue
Core Insights: A high Capex-to-revenue ratio could signal heavy investment in growth or infrastructure. Similarly, understanding working capital movements—like inventory, receivables, and payables—helps evaluate the company's operational efficiency and liquidity.
In an acquisition I worked on, the target company had substantial working capital tied up in excess inventory, which affected its liquidity. This analysis helped identify areas where working capital management could be optimized.
Color-code your financial models with one click!
ProForma is an Excel add-in that automatically splits inputs from formulas, flags links to other sheets and hidden hardcoded plugs.
Profitability and Return on Investment (ROIC)
What’s the return on investment for shareholders? This is one of the most critical aspects of financial ratio analysis. By assessing ROIC and comparing it with the Weighted Average Cost of Capital (WACC), you can gauge whether a company is generating value for its investors.
Key Ratios: ROIC, EBITDA as % of revenue, operating profitability
Core Insights: A high ROIC suggests efficient use of capital. A low ROIC compared to WACC may signal that the company is not generating sufficient returns to justify its cost of capital, raising concerns for potential investors.
During a deal, I noted that the target had a high WACC but was generating an ROIC below that threshold. This raised red flags for potential acquirers, indicating that substantial changes would be needed post-deal to improve returns.
Capital Structure and Cash Flow: Stability and Liquidity
Another key area to analyze is capital structure. How much debt is the company carrying, and can it cover its interest obligations? Financial leverage ratios and cash flow analysis provide insights into a company’s ability to meet short- and long-term obligations.
Key Ratios: Net debt/EBITDA, Interest cover, Free Operating Cash Flow (FOCF) vs. debt service
Core Insights: Strong cash flow generation ensures that a company can meet its debt obligations and continue investing in growth. A low interest coverage ratio or high leverage could be a cause for concern in an acquisition scenario.
In one particular deal, the company had a solid cash flow position, but its high debt-to-equity ratio made potential lenders nervous. However, after analyzing the cash flow patterns and debt service capacity, we were able to structure a deal that alleviated some of those concerns.
Per Share Ratios: Assessing Value and Growth Potential
Lastly, don’t forget to dive into the per share data ratios to assess the company’s value. Key ratios like earnings per share (EPS) and dividend payout are essential when comparing a business to its peers or evaluating its stock performance.
Key Ratios: Basic and diluted EPS, Payout ratio, Dividend per share
Core Insights: These ratios give insight into how profitable a company is on a per-share basis and how much cash is being returned to shareholders through dividends.
In many of my modeling scenarios, understanding EPS and payout ratios was crucial for assessing potential investor interest, particularly in publicly traded M&A transactions.
Color-code your financial models with one click!
ProForma is an Excel add-in that automatically splits inputs from formulas, flags links to other sheets and hidden hardcoded plugs.
Conclusion: Why Financial Ratio Analysis Matters in M&A
Financial ratio analysis is more than just a set of numbers—it’s the lens through which you can evaluate the true performance and potential of a business. Whether you’re assessing revenue drivers, profitability, working capital efficiency, or capital structure, these ratios offer powerful insights that can guide strategic decisions, especially in M&A.
If you’re involved in financial modeling or M&A, how do you approach ratio analysis? What has been the most surprising insight you've discovered when working with financial data?
