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Financial Ratio Analysis

Ratios are typically grouped into four main categories:

  1. Liquidity: Measures a company's ability to meet its short-term obligations.
  2. Activity (or Efficiency): Measures how effectively a company uses its assets.
  3. Solvency (or Leverage): Measures a company's ability to meet its long-term obligations and its overall financial risk.
  4. Profitability: Measures a company's ability to generate earnings.

Liquidity Ratios​

Current Ratio​

The current ratio measures a company's ability to pay off its short-term liabilities with its short-term assets (current assets).

Current AssetsCurrent Liabilities\frac{\text{Current Assets}}{\text{Current Liabilities}}

Quick Ratio (Acid-Test Ratio)​

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets (excluding inventory).

Cash+Marketable Securities+Net Accounts ReceivableCurrent Liabilities\frac{\text{Cash} + \text{Marketable Securities} + \text{Net Accounts Receivable}}{\text{Current Liabilities}}

Activity (Efficiency) Ratios​

These ratios, often called "turnover" ratios, measure how quickly a company converts assets into cash or sales.

Accounts Receivable Turnover​

Measures how many times, on average, the company collects its receivables during a period.

Net Credit SalesAverage Net Accounts Receivable \frac{\text{Net Credit Sales}}{\text{Average Net Accounts Receivable}}

What it means: A higher number is better — the company collects cash faster.

Days Sales Outstanding (DSO)​

Average number of days it takes to collect cash from a credit sale.

365 daysAccounts Receivable Turnover \frac{365\ \text{days}}{\text{Accounts Receivable Turnover}}

What it means: A lower number is better.

Inventory Turnover​

How many times, on average, the company sells and replaces its inventory in a period.

Cost of Goods SoldAverage Inventory \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

What it means: A higher number generally indicates strong sales and less risk of obsolete inventory.

Days in Inventory​

Average number of days inventory is held before being sold.

365 daysInventory Turnover \frac{365\ \text{days}}{\text{Inventory Turnover}}

What it means: A lower number is better.

Solvency (Leverage) Ratios 🏛️​

These ratios measure a company's long-term financial health and its ability to survive over a long period. They focus on debt.

Debt-to-Assets Ratio​

The percentage of the company's assets that are financed by debt.

Total LiabilitiesTotal Assets\frac{\text{Total Liabilities}}{\text{Total Assets}}

What it means: A lower number is less risky. For example, a ratio of 0.6 means 60% of assets are funded by creditors.

Debt-to-Equity Ratio​

Compares what the company owes (liabilities) to what it owns (equity).

Total LiabilitiesTotal Equity\frac{\text{Total Liabilities}}{\text{Total Equity}}

What it means: A lower number is less risky. A ratio of 1.0 means debt and equity are equal.

Times Interest Earned (TIE) Ratio​

Measures the company's ability to make its interest payments from operating profit.

Earnings Before Interest and Taxes (EBIT)Interest Expense\frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}}

What it means: A higher number is safer. A TIE of 5 means operating profit can cover interest expense five times over.

Profitability Ratios 📈​

These ratios measure how well the company generates profit from its operations.

Gross Profit Margin (or Gross Margin)​

The percentage of each sales dollar left after paying for the goods themselves; measures basic pricing power and production efficiency.

Net Sales−Cost of Goods SoldNet Sales\frac{\text{Net Sales} - \text{Cost of Goods Sold}}{\text{Net Sales}}

Net Profit Margin​

The percentage of each sales dollar that becomes profit after all expenses (COGS, operating, interest, and taxes) are paid.

Net IncomeNet Sales\frac{\text{Net Income}}{\text{Net Sales}}

Return on Assets (ROA)​

Measures how efficiently management is using its assets to generate profit.

Net IncomeAverage Total Assets\frac{\text{Net Income}}{\text{Average Total Assets}}

What it means: A higher percentage is better.

Return on Equity (ROE)​

Measures the return generated for the company's owners (shareholders).

Net IncomeAverage Total Equity\frac{\text{Net Income}}{\text{Average Total Equity}}

What it means: A higher percentage is better.