Guide to Financial Ratios

Financial ratios can be invaluable to investors making decisions about companies in which they might want to invest. A variety of ratios is used by individual investors, institutional investors, and professional analysts. Typically, financial ratios are organized into four categories: 

• Profitability ratios
• Liquidity ratios
• Solvency ratios
• Valuation ratios or multiples

Generally, ratios are used in combination to gain a fuller picture of a company. Using a particular ratio as a comparison tool for more than one company can shed light on the less risky or most attractive. Additionally, for a view of past performance, an investor can compare a ratio for certain data today to historical results derived from the same ratio.

Investors can put ratios to use in different ways. All in all, financial ratios can provide a comprehensive view of a company from different angles and help investors spot potential red flags.

In this article, we'll look at each ratio category, the formulas, and some essential explanations.

Profitability Ratios

Profitability is a key aspect to analyze when considering an investment in a company. This is because high revenues alone don't necessarily translate into high earnings or high dividends.

Essentially, profitability analysis seeks to determine whether a company will make a profit. It examines business productivity from multiple angles using a few different scenarios.

Profitability ratios use data from a specific point in time to provide insight into how much profit a company generates and how that profit relates to other important information about the company.

These ratios are used to assess a business' ability to generate earnings relative to its revenue, operating costs, assets, and shareholders' equity over time.

Some key profitability ratios include:

• Gross margin (and adjusted gross margin)
• Operating margin 
• Net profit margin
• EBITDA margin
• Operating cash flow margin
• Return on assets (ROA)
• Return on equity (ROE)
• Return on invested capital (ROIC)
• Return on investment (ROI)

One of the leading ratios used by investors for a quick check of profitability is the net profit margin.

Example: Net Profit Margin

$\text{Profit Margin}=\frac{\text{Net Income}}{\text{Revenue}}$Profit Margin=RevenueNet Income​

This ratio compares a company’s net income to its revenue. In general, the higher a company's profit margin, the better. A net profit margin of 1, or 100%, means a company is converting all of its revenue to net income.

Profit margin levels vary across industries and time periods. Thus, it is helpful to look at a company's net profit margin versus the industry and the company’s historical average.

With net profit margin, there can be a few red flags you should watch out for. For instance, a company that has decreasing profit margins year-over-year could be dealing with changing market conditions, increasing competition, or rising costs.

A company with a very low profit margin may need to focus on decreasing expenses through wide-scale strategic initiatives.

A high-profit margin relative to the industry may indicate a significant advantage in economies of scale, or, potentially, some accounting schemes that may not be sustainable for the long term.

Liquidity Ratios

Liquidity relates to how quickly a company can repay its debts. It indicates how well company assets cover expenses.

Liquidity ratios give investors an idea of a company’s operational efficiency. They also show how quickly and easily a company can generate cash to purchase additional assets or to repay creditors. This need can arise in an emergency situation or in the normal course of business.

Some of the key liquidity ratios include:

• Current ratio
• Quick ratio
• Cash ratio
• Cash conversion cycle (CCC)
• Operating cash flow ratio
• Receivables turnover
• Inventory turnover
• Working capital turnover

Example: Current and Quick Ratios

The current and quick ratios are great ways to assess the liquidity of a firm. The ratios are similar.

The current ratio is calculated by dividing current assets by current liabilities. Since current assets and current liabilities represent activity in the upcoming 12 months, this ratio can provide insight into the firm’s short-term liquidity.

A higher current ratio is favorable as it represents the number of times current assets can cover current liabilities. However, one that's too high might indicate that a company isn't utilizing its excess cash as well as it could to pursue growth.

The quick ratio differs slightly. Its calculation subtracts inventory from current assets before they're divided by current liabilities. This ratio can present better insight into the short-term liquidity of the firm because of the exclusion of inventory.

A higher quick ratio indicates more short-term liquidity and good financial health.

Solvency Ratios

Solvency ratios, also known as leverage ratios, are used by investors to see how well a company can deal with its long-term financial obligations. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt.

Some of the most popular solvency ratios include:

• Debt-to-total-assets
• Debt-to-equity
• Time interest earned
• Interest coverage ratio
• Net income to liabilities
• Times interest earned 

Debt-to-assets and debt-to-equity are two ratios often used for a quick check of a company’s debt levels. They review how debt stacks up against the categories of assets and equity on the balance sheet. They give investors an idea of a company's financial health as it relates to a potential burden of debt.

Example: Debt-to-Assets

The total-debt-to-total-assets ratio is used to determine how much of a company is financed by debt rather than shareholder equity.

It is calculated as follows:

$\begin{aligned}&\text{Total Debt to Total Assets}\ =\ \frac{\text{STD}\ +\ \text{LTD}}{\text{Total Assets}}\\&\textbf{where:}\\&\text{STD}=\text{short term debt}\\&\text{LTD}=\text{long term debt}\end{aligned}$​Total Debt to Total Assets = Total AssetsSTD + LTD​where:STD=short term debtLTD=long term debt​

A smaller percentage is better because it means that a company carries less debt compared to its total assets. The greater the percentage of assets, the better a company's solvency.

Remember, lenders typically have the first claim on a company's assets if it's required to liquidate. A lower debt-to-assets ratio typically indicates less risk.

When using this ratio to analyze a company, it can help to look at both the company growth phase and the industry as a whole. It's not unrealistic for a younger company to have a high debt-to-total-assets ratio (with more of its assets financed by debt) as it hasn't had a chance to eliminate its debt.

Valuation Ratios

Valuation ratios are often referred to by the media. They're easy to use to analyze the attractiveness of an investment in a company. These metrics primarily incorporate the price of a company's publicly traded stock. They can give investors an understanding of how inexpensive or expensive the stock is relative to the market.

In general, the lower the ratio level, the more attractive an investment in a company becomes. Often, analysts will take the reciprocal of a valuation ratio, or its multiple, as a measure of relative value.

Popular valuation multiples include:

• Price-to-earnings
• Price-to-book
• Price-to-sales
• Price-to-cash flow

Example: Price-to-Earnings

The price-to-earnings (P/E) ratio is a well-known valuation ratio. It compares a company's stock price to its earnings on a per-share basis. It can help investors determine a stock's potential for growth.

The P/E ratio is calculated as follows:

$\text{Price to Earnings} = \frac{\text{Market Value Per Share}}{\text{Earnings Per Share (EPS)}}$Price to Earnings=Earnings Per Share (EPS)Market Value Per Share​

Basically, the P/E tells you how much investors are willing to pay for $1 of earnings in that company. The higher the ratio, the more investors will spend.

The P/E ratio can signal whether a stock is undervalued or overvalued. Bear in mind that different industries have substantially different P/E ratios. So, it's important to compare a company's P/E ratio to that of other companies in the same industry and to the P/E for the industry itself.

The Bottom Line

Financial ratios can be used to compare companies. They can help investors evaluate stocks within an industry. Moreover, they can provide a measure of a company today that can be compared to its historical data.

The information you need to calculate ratios is easy to come by. Every figure can be found in a company's financial statements. Once you have the raw data, you can plug it into your financial analysis tools and put it to work for you.

Investors want tools that can give them an edge. However, some of the best and perhaps easiest to use tools are frequently misunderstood and avoided by new investors.

Understanding what financial ratios tell you and how to calculate them can give you greater confidence in your investment decisions and help you avoid investment mistakes.