1. Liquidity Ratios?
These ratios measure a company’s ability to pay off its short-term debts with its available assets.
- Current Ratio = Current Assets / Current Liabilities
This shows whether a company has enough assets to cover its short-term obligations.
- Example: A ratio of 2.0 means the company has $2 in assets for every $1 in debt.
- Quick Ratio = (Current Assets – Inventory) / Current Liabilities
This is a more strict measure of liquidity because it excludes inventory, which may not be sold quickly.
2. Profitability Ratios?
These ratios assess a company’s ability to generate profit compared to its expenses and other costs.
- Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
This tells you how much profit a company makes after subtracting the costs directly tied to making products.- Example: A 40% gross profit margin means 40% of the revenue remains after covering production costs.
- Net Profit Margin = Net Income / Revenue
This measures how much of the revenue is turned into actual profit after all expenses.- Example: A 10% net profit margin means the company keeps $0.10 as profit for every $1 of revenue.
3. Leverage Ratios?
Leverage ratios evaluate how much debt a company uses to finance its assets.
- Debt-to-Equity Ratio = Total Debt / Total Equity
This shows how much a company relies on debt versus shareholders’ equity to fund its operations.- Example: A debt-to-equity ratio of 1.5 means the company has $1.50 in debt for every $1 of equity.
- Interest Coverage Ratio = EBIT (Earnings Before Interest & Taxes) / Interest Expense
This ratio measures the company’s ability to pay its interest expenses.- Example: A ratio of 3 means the company earns three times what it needs to pay its interest obligations.
4. Efficiency Ratios?
Efficiency ratios determine how well a company uses its assets and manages its operations.
- Asset Turnover Ratio = Revenue / Total Assets
This shows how efficiently a company generates revenue from its assets.- Example: A ratio of 1.5 means the company generates $1.50 in sales for every $1 in assets.
- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
This ratio shows how often a company sells and replaces its inventory.- Example: A higher turnover ratio means inventory is being sold quickly, which is usually a good sign.
5. Market Ratios?
These ratios provide insights into the company’s market performance and investor expectations.
- Earnings Per Share (EPS) = (Net Income – Dividends on Preferred Stock) / Average Shares Outstanding
This shows how much profit is allocated to each share of stock.- Example: A higher EPS indicates more profit for shareholders.
- Price-to-Earnings Ratio (P/E) = Stock Price / Earnings Per Share
This shows what investors are willing to pay for each dollar of earnings.- Example: A P/E ratio of 20 means investors are willing to pay $20 for $1 of current earnings.
Why Use Financial Ratios?
- Compare Companies: Ratios make it easier to compare companies of different sizes in the same industry.
- Track Performance: You can track how well a company is doing over time and against competitors.
- Identify Trends: Ratios help spot trends in a company’s operations and financial stability.
Conclusion
Financial ratio analysis is a simple yet powerful way to gauge a company’s health and performance. By focusing on key ratios, you can make more informed decisions, whether you’re investing in a stock or managing a business.