Financial Ratio Categories

Why This Matters

Financial ratios are the language of corporate valuation—they translate raw financial statements into actionable insights about a company's health, risk profile, and growth potential. You're being tested on your ability to not just calculate these ratios, but to understand what story they tell about a business. Exam questions will ask you to diagnose company performance, compare firms across industries, and identify red flags that signal financial distress or hidden value.

The key insight here is that ratios don't exist in isolation. They form an interconnected system where liquidity, profitability, leverage, and efficiency all influence each other. A company with stellar profitability but terrible liquidity can still fail. A firm with high debt might be perfectly healthy—or heading toward bankruptcy. Don't just memorize formulas—know which ratios answer which strategic questions, and how they work together to paint a complete picture of corporate value.

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Short-Term Financial Health

These ratios answer a fundamental question: Can the company pay its bills right now? They measure the cushion between current assets and current liabilities, revealing whether a firm has breathing room or is living paycheck to paycheck.

Liquidity Ratios

• Current Ratio and Quick Ratio—the two workhorses that compare current assets to current liabilities, with Quick Ratio excluding inventory for a more conservative view
• Higher values indicate safety cushions, but excessively high ratios may signal inefficient asset deployment or poor cash management
• Industry context matters—retailers carry more inventory, so their Quick Ratios naturally run lower than service firms

Cash Flow Ratios

• Operating Cash Flow Ratio—measures actual cash generated from operations relative to current liabilities, revealing whether reported profits translate to real cash
• Free Cash Flow Ratio—indicates cash available after capital expenditures for debt repayment, dividends, or reinvestment
• Quality of earnings test—strong cash flow ratios validate that accounting profits aren't just paper gains

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Profitability and Operational Performance

These ratios reveal how effectively management converts resources into profits. They're essential for comparing companies of different sizes and assessing whether a business model actually works.

Profitability Ratios

• Gross Profit Margin—shows pricing power and production efficiency, calculated as $\frac{\text{Revenue} - \text{COGS}}{\text{Revenue}}$
• Operating Margin and Net Margin—reveal how much profit survives after operating expenses and all costs, respectively
• Return on Equity (ROE)—the ultimate profitability metric for shareholders, measuring profit generated per dollar of equity invested

Efficiency Ratios

• Asset Turnover Ratio—indicates how many dollars of revenue each dollar of assets generates, a key driver of ROE through the DuPont framework
• Inventory Turnover Ratio—measures how quickly inventory sells, with higher values suggesting strong demand or lean operations
• Receivables Turnover—reveals how efficiently the company collects from customers, directly impacting cash conversion

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Long-Term Financial Stability

These ratios assess structural risk—whether a company's capital structure is sustainable and whether it can weather economic downturns without defaulting on obligations.

Solvency Ratios

• Debt to Equity Ratio—measures financial leverage by comparing total debt to shareholder equity, with higher values indicating greater risk and potential return amplification
• Debt to Assets Ratio—shows what percentage of the company's assets are financed by debt rather than equity
• Lower solvency ratios suggest stability, but some leverage is optimal for minimizing weighted average cost of capital (WACC)

Coverage Ratios

• Interest Coverage Ratio—calculated as $\frac{\text{EBIT}}{\text{Interest Expense}}$, indicating how many times over the company can pay its interest obligations
• Debt Service Coverage Ratio (DSCR)—broader measure including principal repayments, critical for lenders assessing loan covenants
• Threshold values matter—coverage below 1.5x often triggers covenant violations or signals distress

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Market Perception and Growth Potential

These ratios capture investor expectations and forward-looking value. They bridge accounting data and market prices, revealing whether a stock is potentially overvalued or undervalued.

Market Value Ratios

• Price to Earnings (P/E) Ratio—compares stock price to earnings per share, with high P/E suggesting growth expectations or overvaluation
• Price to Book (P/B) Ratio—relates market value to book value of equity, particularly useful for asset-heavy industries like banking
• Enterprise Value multiples (EV/EBITDA)—preferred for comparing firms with different capital structures since it's capital-structure neutral

Growth Ratios

• Earnings Growth Rate—measures year-over-year change in net income or EPS, indicating momentum and scalability
• Revenue Growth Rate—top-line expansion that drives long-term value, though growth without profitability destroys value
• Sustainable Growth Rate—calculated as $\text{ROE} \times \text{Retention Ratio}$, showing maximum growth achievable without external financing

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Quick Reference Table

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Self-Check Questions

1. Which two ratio categories would you analyze together to determine whether a highly leveraged company is at risk of default, and why?

2. A company has strong profitability ratios but weak cash flow ratios. What does this discrepancy suggest about earnings quality, and what might be causing it?

3. Compare and contrast the Current Ratio and Operating Cash Flow Ratio—when might they give conflicting signals about a company's short-term health?

4. Using the DuPont framework, explain how a discount retailer and a luxury brand might achieve similar ROE through different combinations of margin, turnover, and leverage.

5. An FRQ asks you to evaluate whether a stock is overvalued. Which ratio categories would you use, and what specific comparisons would strengthen your analysis?