Financial ratios transform raw financial data into meaningful metrics for comparison and analysis. These tools help you evaluate profitability, valuation, financial health, and efficiency across different companies and industries.
Valuation Ratios
Price-to-Earnings (P/E) Ratio
Formula: Stock Price ÷ Earnings Per Share (EPS)
What It Shows: How much investors pay for $1 of earnings
Interpretation:
- Lower P/E = potentially cheaper
- Higher P/E = growth expectations or overvaluation
- Compare within industry
Example: Stock price $50, EPS $5 = P/E of 10
Types:
- Trailing P/E: Past 12 months earnings
- Forward P/E: Projected future earnings
Price-to-Book (P/B) Ratio
Formula: Stock Price ÷ Book Value Per Share
What It Shows: Price relative to accounting value
Interpretation:
- P/B < 1 = trading below book value
- Useful for asset-heavy companies
- Less useful for tech companies
Example: Stock $30, Book value $15 = P/B of 2
Price-to-Sales (P/S) Ratio
Formula: Market Cap ÷ Revenue (or Price ÷ Sales Per Share)
What It Shows: Valuation relative to revenue
When Useful:
- Companies without profits
- Comparing similar companies
- Growth companies
PEG Ratio
Formula: P/E Ratio ÷ Earnings Growth Rate
What It Shows: P/E adjusted for growth
Interpretation:
- PEG < 1 = potentially undervalued
- PEG > 1 = potentially overvalued
- Accounts for growth differences
Example: P/E of 20, Growth rate 25% = PEG of 0.8
Enterprise Value / EBITDA
Formula: Enterprise Value ÷ EBITDA
What It Shows: Valuation relative to operating earnings
Advantage:
- Accounts for debt
- More comprehensive than P/E
- Good for comparisons
Profitability Ratios
Gross Profit Margin
Formula: (Revenue - COGS) ÷ Revenue × 100
What It Shows: Profit after direct costs
Interpretation:
- Higher is better
- Indicates pricing power
- Compare within industry
Operating Profit Margin
Formula: Operating Income ÷ Revenue × 100
What It Shows: Profit from core operations
Importance:
- Shows operational efficiency
- Before interest and taxes
- Management effectiveness
Net Profit Margin
Formula: Net Income ÷ Revenue × 100
What It Shows: Bottom-line profitability
Interpretation:
- What % of sales becomes profit
- Compare to competitors
- Watch trends
Example: $10M net income, $100M revenue = 10% margin
Return on Equity (ROE)
Formula: Net Income ÷ Shareholders' Equity × 100
What It Shows: Profit generated from shareholders' investment
Interpretation:
- Higher generally better
- 15%+ considered good
- Too high may indicate high debt
Return on Assets (ROA)
Formula: Net Income ÷ Total Assets × 100
What It Shows: How efficiently assets generate profit
Interpretation:
- Higher is better
- Compare within industry
- Asset-heavy industries have lower ROA
Return on Invested Capital (ROIC)
Formula: NOPAT ÷ Invested Capital × 100
What It Shows: Return on all capital employed
Importance:
- Comprehensive return measure
- Should exceed cost of capital
- Warren Buffett favorite
Liquidity Ratios
Current Ratio
Formula: Current Assets ÷ Current Liabilities
What It Shows: Ability to pay short-term obligations
Interpretation:
- > 1 means more assets than liabilities
- 1.5-2 generally healthy
- Too high may mean inefficient asset use
Quick Ratio (Acid Test)
Formula: (Current Assets - Inventory) ÷ Current Liabilities
What It Shows: Ability to pay without selling inventory
More Conservative:
- Excludes harder-to-sell inventory
- > 1 is generally good
- Important for some industries
Cash Ratio
Formula: Cash + Cash Equivalents ÷ Current Liabilities
What It Shows: Ability to pay with cash on hand
Most Conservative:
- Only cash counted
- Very conservative measure
Debt/Leverage Ratios
Debt-to-Equity Ratio
Formula: Total Debt ÷ Shareholders' Equity
What It Shows: Debt relative to ownership
Interpretation:
- Lower generally safer
- Industry dependent
- < 1 is conservative
Debt-to-Assets Ratio
Formula: Total Debt ÷ Total Assets
What It Shows: Percentage of assets financed by debt
Interest Coverage Ratio
Formula: EBIT ÷ Interest Expense
What It Shows: Ability to pay interest on debt
Interpretation:
- Higher is better
- < 1.5 is concerning
- Important for heavily indebted companies
Efficiency Ratios
Asset Turnover
Formula: Revenue ÷ Total Assets
What It Shows: How efficiently assets generate sales
Inventory Turnover
Formula: Cost of Goods Sold ÷ Average Inventory
What It Shows: How quickly inventory sells
Higher Means:
- Faster selling
- Less money tied up
- More efficient
Receivables Turnover
Formula: Revenue ÷ Average Accounts Receivable
What It Shows: How quickly collecting payments
Using Ratios Effectively
Compare Within Industry
Important:
- Industries have different norms
- Tech vs utilities very different
- Use sector averages
Look at Trends
Track Over Time:
- Improving or declining?
- Compare to past performance
- Spot turning points
Use Multiple Ratios
Don't Rely on One:
- Each shows different aspect
- Combined picture clearer
- Cross-check conclusions
Understand Limitations
Ratios Don't Show:
- Future performance
- Management quality
- Competitive position
- All risks
Quick Reference Table
| Ratio | Formula | Good Range |
|---|---|---|
| P/E | Price / EPS | 10-25 (varies) |
| P/B | Price / Book | < 3 |
| ROE | Net Income / Equity | > 15% |
| Current | Current A / Current L | 1.5-2 |
| D/E | Debt / Equity | < 1 |
| Net Margin | Net Income / Revenue | Industry dependent |
Key Takeaways
- Valuation ratios compare price to fundamentals
- Profitability ratios measure earnings efficiency
- Liquidity ratios assess short-term health
- Debt ratios evaluate financial risk
- Efficiency ratios show operational effectiveness
- Compare ratios within same industry
- Track ratios over time for trends
- Use multiple ratios together for complete picture
What's Next?
Learn how to analyze earnings reports.
This article is for educational purposes only and does not constitute financial advice.