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Understanding Financial Ratios: A Comprehensive Guide

Financial ratios are created with the use of numerical values taken from financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting., income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or, and cash flow statementCash Flow StatementA cash flow Statement contains information on how much cash a company generated and used during a given period. – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

Financial ratios are grouped into the following categories:

Liquidity ratios
Leverage ratios
Efficiency ratios
Profitability ratios
Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:

External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
Internal users: Management team, employees, and owners

Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:

The current ratioCurrent Ratio FormulaThe Current Ratio formula is = Current Assets / Current Liabilities. The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company measures a company’s ability to pay off short-term liabilities with current assets:

Current ratio = Current assets / Current liabilities

The acid-test ratioAcid-Test RatioThe Acid-Test Ratio, also known as quick ratio, is a liquidity ratio that measures how sufficient a company's short-term assets can cover current liabilities measures a company’s ability to pay off short-term liabilities with quick assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratioCash RatioThe cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s capacity to pay off short-term debt obligations with its cash and cash equivalents. Compared to other liquidity ratios such as the current ratio and quick ratio, the cash ratio is a stricter, more conservative measure measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratioOperating Cash Flow RatioThe Operating Cash Flow Ratio, a liquidity ratio, is a measure of how well a company can pay off its current liabilities with the cash flow generated from its core business operations. This financial metric shows how much a company earns from its operating activities, per dollar of current liabilities. is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

Leverage Financial Ratios

Leverage ratiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:

The debt ratioDebt to Asset RatioThe debt to asset ratio, also known as the debt ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt. measures the relative amount of a company’s assets that are provided from debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratioFinanceCFI's Finance Articles are designed as self-study guides to learn important finance concepts online at your own pace. Browse hundreds of articles! calculates the weight of total debt and financial liabilities against shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratioInterest Coverage RatioInterest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:

The asset turnover ratioAsset TurnoverAsset turnover measures the value of revenue generated by a business relative to its average total assets for a given fiscal year. measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratioInventory TurnoverInventory turnover, or the inventory turnover ratio, is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time. measures how many times a company’s inventory is sold and replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratioDays Sales in Inventory (DSI)Days Sales in Inventory (DSI), sometimes known as inventory days or days in inventory, is a measurement of the average number of days or time measures the average number of days that a company holds on to inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability ratiosProfitability RatiosProfitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets to produce profit measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:

The gross margin ratioGross Margin RatioThe Gross Margin Ratio, also known as the gross profit margin ratio, is a profitability ratio that compares the gross profit of a company to its revenue. compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratioOperating Profit MarginOperating Profit Margin is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue and expressing as a percentage. compares the operating income of a company to its net sales to determine operating efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratioReturn on Assets & ROA FormulaROA Formula. Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. measures how efficiently a company is using its assets to generate profit:

Return on assets ratio = Net income / Total assets

The return on equity ratioReturn on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity. measures how efficiently a company is using its equity to generate profit:

Return on equity ratio = Net income / Shareholder’s equity

Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following:

The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company. compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share

Understanding Financial Ratios: A Comprehensive Guide

Uses and Users of Financial Ratio Analysis

1. Track company performance

2. Make comparative judgments regarding company performance

Liquidity Ratios

Leverage Financial Ratios

Efficiency Ratios

Profitability Ratios

Market Value Ratios

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Authorized Shares: Understanding a Company's Issuance Limit

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