Key Financial Ratios

Why This Matters

Financial ratios are the language of investment analysis—they transform raw financial statements into actionable insights about a company's health, risk, and potential. You're being tested on your ability to not just calculate these ratios but to interpret what they reveal about liquidity, leverage, profitability, efficiency, and valuation. Understanding how analysts use these metrics to compare companies, assess creditworthiness, and make investment decisions is central to financial institutions and markets.

Don't just memorize formulas—know what question each ratio answers. A creditor evaluating loan risk cares about different ratios than an equity investor hunting for undervalued stocks. When you encounter these ratios on exams, ask yourself: Who uses this ratio, and what decision does it inform? That's the thinking that separates surface-level recall from real financial literacy.

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Liquidity Ratios: Can the Company Pay Its Bills?

Liquidity ratios measure a firm's ability to meet short-term obligations as they come due. These ratios matter most to creditors and suppliers who need assurance they'll be paid.

Current Ratio

• Formula: $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$—measures whether short-term assets can cover short-term debts
• Ratio above 1.0 indicates the company has more current assets than current liabilities, suggesting adequate liquidity
• Industry context matters—retailers typically operate with lower current ratios than manufacturers due to faster inventory turnover

Quick Ratio (Acid-Test Ratio)

• Formula: $\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$—strips out inventory for a stricter liquidity test
• Excludes inventory because it's the least liquid current asset and may not convert to cash quickly in a crisis
• Ratio above 1.0 means the company can meet obligations without relying on inventory sales—critical for firms with slow-moving stock

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Leverage Ratios: How Much Risk Is the Company Taking?

Leverage ratios reveal how a company finances its operations—through debt or equity—and its capacity to service that debt. Higher leverage amplifies both returns and risks.

Debt-to-Equity Ratio

• Formula: $\text{D/E Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}$—shows the proportion of debt versus owner investment
• Higher ratios indicate greater financial leverage, meaning more risk but potentially higher returns for equity holders
• Critical for assessing capital structure—banks and creditors use this to evaluate long-term solvency before extending credit

Interest Coverage Ratio

• Formula: $\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}}$—measures how easily a firm can pay interest on outstanding debt
• Higher ratios signal lower default risk—a ratio below 1.5 often raises red flags for creditors
• Key metric for bond investors and credit rating agencies assessing a company's ability to service debt obligations

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Profitability Ratios: Is the Company Making Money?

Profitability ratios measure how effectively a company converts revenue and assets into profit. These ratios are essential for comparing performance across competitors and evaluating management effectiveness.

Profit Margin

• Formula: $\text{Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times 100$—shows what percentage of each dollar in sales becomes profit
• Higher margins indicate better cost control and pricing power relative to competitors
• Varies dramatically by industry—grocery stores operate on thin margins (~2%), while software companies may exceed 20%

Operating Margin

• Formula: $\text{Operating Margin} = \frac{\text{Operating Income}}{\text{Revenue}} \times 100$—focuses on core business profitability before interest and taxes
• Isolates operational efficiency by excluding financing decisions and tax strategies
• Better for comparing competitors since it removes capital structure differences from the analysis

Return on Equity (ROE)

• Formula: $\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}} \times 100$—measures profit generated per dollar of shareholder investment
• Higher ROE indicates effective management and efficient use of investor capital
• Can be artificially inflated by high leverage—always examine alongside D/E ratio to understand the full picture

Return on Assets (ROA)

• Formula: $\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} \times 100$—shows how efficiently a company uses all assets to generate profit
• Unaffected by capital structure, making it useful for comparing firms with different financing strategies
• Asset-intensive industries (utilities, manufacturing) typically show lower ROA than asset-light businesses (consulting, software)

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Efficiency Ratios: How Well Does the Company Use Its Resources?

Efficiency ratios—also called activity ratios or turnover ratios—measure how effectively a company manages its assets and operations to generate revenue.

Asset Turnover Ratio

• Formula: $\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Total Assets}}$—indicates how many dollars of sales each dollar of assets generates
• Higher ratios suggest better asset utilization—the company is squeezing more revenue from its resource base
• Inversely related to profit margins in many industries—high-turnover businesses (retail) often have lower margins than low-turnover businesses (luxury goods)

Inventory Turnover Ratio

• Formula: $\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$—measures how quickly inventory sells and is replaced
• Higher turnover indicates efficient inventory management and strong demand for products
• Low turnover may signal obsolete inventory or weak sales—a liquidity concern if inventory can't be converted to cash

Accounts Receivable Turnover Ratio

• Formula: $\text{AR Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$—measures how effectively a company collects from customers
• Higher ratios indicate efficient collection processes and strong cash flow management
• Low turnover suggests credit policy problems—customers aren't paying on time, which strains working capital

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Valuation Ratios: What Is the Stock Worth?

Valuation ratios help investors determine whether a stock is fairly priced relative to its earnings, assets, or dividends. These ratios are central to equity analysis and investment decision-making.

Earnings Per Share (EPS)

• Formula: $\text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}$—measures profit attributable to each common share
• Primary metric for gauging profitability on a per-share basis, making comparisons across companies possible
• Watch for dilution—stock splits and new share issuances can reduce EPS even if total earnings grow

Price-to-Earnings (P/E) Ratio

• Formula: $\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}$—shows how much investors pay for each dollar of earnings
• High P/E may indicate overvaluation or high growth expectations; low P/E may signal undervaluation or concerns about future earnings
• Most useful for comparing companies in the same industry—tech firms typically trade at higher P/E ratios than utilities

Price-to-Book (P/B) Ratio

• Formula: $\text{P/B Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}$—compares market valuation to accounting value of equity
• P/B below 1.0 may indicate undervaluation—the market values the company at less than its net asset value
• Particularly useful for asset-heavy industries like banking, real estate, and manufacturing where book value is meaningful

Dividend Yield

• Formula: $\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Market Price per Share}} \times 100$—measures cash return to shareholders as a percentage of stock price
• Higher yields attract income-focused investors seeking regular cash payments rather than capital appreciation
• Very high yields may signal risk—a falling stock price inflates yield, potentially indicating the dividend is unsustainable

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Quick Reference Table

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Self-Check Questions

1. Which two ratios both measure liquidity, and why might an analyst prefer one over the other when evaluating a company with significant inventory?

2. A company has high ROE but relatively low ROA. What does this likely indicate about its capital structure, and what additional ratio should you examine?

3. Compare and contrast the P/E ratio and P/B ratio—when would each be most useful for valuation analysis?

4. If an FRQ asks you to assess whether a company can meet its debt obligations, which ratios would you analyze and why?

5. A retail company shows declining inventory turnover but stable AR turnover. What operational problem might this indicate, and how could it affect the company's liquidity ratios?