Financial ratios are numerical calculations that illustrate the relationship between one piece or group of data and another. Business owners use financial statement ratios to performance, assess risk and guide decision-making. For investors, these calculations can provide meaningful data that reflects a company’s liquidity and financial health.
The use of financial ratios is often central to a quantitative or fundamental analysis approach, though they can also be used for technical analysis. For example, a value investor may use certain types of financial ratios to indicate whether the market has undervalued a company or how much potential its stock has for long-term price appreciation. Meanwhile, a trend trader may check key financial ratios to determine if a current pricing trend is likely to hold.
With either strategy, informed investors must understand the different kinds of commonly used financial ratios, and how to interpret them.
Key Points
• Financial ratios serve as essential tools for evaluating a company’s performance, risk, and overall financial health, assisting both business owners and investors in decision-making.
• Key financial ratios include Earnings Per Share (EPS), Price-to-Earnings (P/E), and Debt to Equity (D/E), each providing insights into profitability, valuation, and leverage.
• Liquidity ratios, such as the Current Ratio and Quick Ratio, help assess a company’s ability to meet short-term obligations, crucial for evaluating newer firms.
• Profitability ratios, including Gross Margin and Return on Assets, gauge how effectively a company generates income from its operations and assets.
• Coverage ratios, like the Debt Service Coverage Ratio and Interest Coverage Ratio, measure a company’s capacity to manage its debt obligations, providing insights into financial stability.
What Are Financial Ratios?
A financial ratio is a means of expressing the relationship between two pieces of numerical data. When discussing ratios in a business or investment setting, you’re typically talking about information that’s included in a company’s financial statements.
Recommended: How to Read Financial Statements
Financial ratios can provide insight into a company, in terms of things like valuation, revenues, and profitability. They can also aid in comparing two companies.
For example, say you’re considering investing in the tech sector, and you are evaluating two potential companies. One has a share price of $10 while the other has a share price of $55. Basing your decision solely on price alone could be a mistake if you don’t understand what’s driving share prices or how the market values each company. That’s where financial ratios become useful for understanding a company’s inner workings.
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Key Financial Ratios
Investors tend to use some financial ratios more often or place more significance on certain ratios when evaluating business or companies. Here are some of the most important financial ratios to know.
1. Earnings Per Share (EPS)
Earnings per share or EPS measures earnings and profitability. This metric can tell you how likely a company is to generate profits for its investors. A higher EPS typically indicates better profitability, though this rule works best when making apples-to-apples comparisons for companies within the same industry.
EPS Formula:
EPS = Net profit / Number of common shares
To find net profit, you’d subtract total expenses from total revenue. (Investors might also refer to net profit as net income.)
EPS Example:
So, assume a company has a net profit of $2 million, with 12,000,000 shares outstanding. Following the EPS formula, the earnings per share works out to $0.166.
2. Price-to-Earnings (P/E)
Price-to-earnings ratio or P/E helps investors determine whether a company’s stock price is low or high compared to other companies or to its own past performance. More specifically, the price-to-earnings ratio can give you a sense of how expensive a stock is relative to its competitors, or how the stock’s price is trending over time.
P/E Formula:
P/E = Current stock price / Current earnings per share
P/E Example:
Here’s how it works: A company’s stock is trading at $50 per share. Its EPS for the past 12 months averaged $5. The price-to-earnings ratio works out to 10, meaning investors would have to spend $10 for every dollar generated in annual earnings.
3. Debt to Equity (D/E)
Debt to equity or D/E is a leverage ratio. This ratio tells investors how much debt a company has in relation to how much equity it holds.
D/E Formula:
D/E = Total liabilities / Shareholders equity
In this formula, liabilities represent money the company owes. Equity represents assets minus liabilities or the company’s book value.
D/E Example:
Say a company has $5 million in debt and $10 million in shareholder equity. Its debt-to-equity ratio would be 0.5. As a general rule, a lower debt to equity ratio is better as it means the company has fewer debt obligations.
4. Return on Equity (ROE)
Return on equity or ROE is another financial ratio that’s used to measure profitability. In simple terms, it’s used to illustrate the return on shareholder equity based on how a company spends its money.
ROE Formula:
ROE = Net income – Preferred dividends / Value of average common equity
ROE Example:
Assume a company has net income of $2 million and pays out preferred dividends of $200,000. The total value of common equity is $10 million. Using the formula, return on equity would equal 0.18 or 18%. A higher ROE means the company generates more profits.
Liquidity Ratios
Liquidity ratios can give you an idea of how easily a company can pay its debts and other liabilities. In other words, liquidity ratios indicate cash flow strength. That can be especially important when considering newer companies, which may face more significant cash flow challenges compared to established companies.
5. Current Ratio
Also known as the working-capital ratio, the current ratio tells you how likely a company is able to meet its financial obligations for the next 12 months. You might check this ratio if you’re interested in whether a company has enough assets to pay off short-term liabilities.
Formula:
Current Ratio = Current Assets / Current Liabilities
Example:
Say a company has $1 million in current assets and $500,000 in current liabilities. It has a current ratio of 2, meaning for every $1 a company has in current liabilities it has $2 in current assets.
6. Quick Ratio
The quick ratio, also called the acid-test ratio, measures liquidity based on assets and liabilities. But it deducts the value of inventory from these calculations.
Formula:
Quick Ratio = Current Assets – Inventory / Current Liabilities
Example:
Quick ratio is also useful for determining how easily a company can pay its debts. For example, say a company has current assets of $5 million, inventory of $1 million and current liabilities of $500,000. Its quick ratio would be 8, so for every $1 in liabilities the company has $8 in assets.
7. Cash Ratio
A cash ratio tells you how much cash a company has on hand, relative to its total liabilities. Essentially, it tells you how easily a company could pay its liabilities with cash.
Formula:
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
Example:
A company that has $100,000 in cash and $500,000 in current liabilities would have a cash ratio of 0.2. That means it has enough cash on hand to pay 20% of its current liabilities.
8. Operating Cash Flow Ratio
Operating cash flow can tell you how much cash flow a business generates in a given time frame. This financial ratio is useful for determining how much cash a business has on hand at any given time that it can use to pay off its liabilities.
To calculate the operating cash flow ratio you’ll first need to determine its operating cash flow:
Operating Cash Flow = Net Income + Changes in Assets & Liabilities + Non-cash Expenses – Increase in Working Capital
Then, you calculate the cash flow ratio using this formula:
Formula:
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Example:
For example, if a company has an operating cash flow of $1 million and current liabilities of $250,000, you could calculate that it has an operating cash flow ratio of 4, which means it has $4 in operating cash flow for every $1 of liabilities.
Solvency Ratios
Solvency ratios are financial ratios used to measure a company’s ability to pay its debts over the long term. As an investor, you might be interested in solvency ratios if you think a company may have too much debt or be a potential candidate for a bankruptcy filing. Solvency ratios can also be referred to as leverage ratios.
Debt to equity is a key financial ratio used to measure solvency, though there are other leverage ratios that are helpful as well.
9. Debt Ratio
A company’s debt ratio measures the relationship between its debts and its assets. For instance, you might use a debt ratio to gauge whether a company could pay off its debts with the assets it has currently.
Formula:
Debt Ratio = Total Liabilities / Total Assets
Example:
The lower this number is the better in terms of risk. A lower debt ratio means a company has less relative debt. So a company that has $25,000 in debt and $100,000 in assets, for example, would have a debt ratio of 0.25. Investors typically consider anything below 0.5 a lower risk.
10. Equity Ratio
Equity ratio is a measure of solvency based on assets and total equity. This ratio can tell you how much of the company is owned by investors and how much of it is leveraged by debt.
Formula:
Equity Ratio = Total Equity / Total Assets
Example:
Investors typically favor a higher equity ratio, as it means the company’s shareholders are more heavily invested and the business isn’t bogged down by debt. So, for example, a company with $200,000 in total equity and $200,000 in total assets has an equity ratio of 0.80. This tells you shareholders own 80% of the company.
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Profitability Ratios
Profitability ratios gauge a company’s ability to generate income from sales, balance sheet assets, operations and shareholder’s equity. In other words, how likely is the company to be able to turn a profit?
Return on equity is one profitability ratio investors can use. You can also try these financial ratios for estimating profitability.
11. Gross Margin Ratio
Gross margin ratio compares a company’s gross margin to its net sales. This tells you how much profit a company makes from selling its goods and services after the cost of goods sold is factored in.
Formula:
Gross Margin Ratio = Gross Margin / Net Sales
Example
A company that has a gross margin of $250,000 and $1 million in net sales has a gross margin ratio of 25%. Meanwhile, a company with a $250,000 gross margin and $2 million in net sales has a gross margin ratio of 12.5% and realizes a smaller profit percentage per sale.
12. Operating-Margin Ratio
Operating-margin ratio measures how much total revenue is composed of operating income, or how much revenue a company has after its operating costs.
Formula:
Operating Margin Ratio = Operating Income / Net Sales
Example:
A higher operating-margin ratio suggests a more financially stable company with enough operating income to cover its operating costs. For example, if operating income is $250,000 and net sales are $500,000, that means 50 cents per dollar of sales goes toward variable costs.
13. Return on Assets Ratio
Return on assets or ROA measures net income produced by a company’s total assets. This lets you see how good a company is at using its assets to generate income.
Formula:
Return on Assets = Net Income / Average Total Assets
Example:
Investors typically favor a higher ratio as it shows that the company may be better at using its assets to generate income. For example, a company that has $10 million in net income and $2 million in average total assets generates $5 in income per $1 of assets.
Efficiency Ratios
Efficiency ratios or financial activity ratios give you a sense of how thoroughly a company is using the assets and resources it has on hand. In other words, they can tell you if a company is using its assets efficiently or not.
14. Asset Turnover Ratio
Asset turnover ratio is a way to see how much sales a company can generate from its assets.
Formula:
Asset Turnover Ratio = Net Sales / Average Total Assets
A higher asset turnover ratio is typically better, as it indicates greater efficiency in terms of how assets are being used to produce sales.
Example:
Say a company has $500,000 in net sales and $50,000 in average total assets. Their asset turnover ratio is 10, meaning every dollar in assets generates $10 in sales.
15. Inventory Turnover Ratio
Inventory turnover ratio illustrates how often a company turns over its inventory. Specifically, how many times a company sells and replaces its inventory in a given time frame.
Formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Example:
Investors use average inventory since a company’s inventory can increase or decrease throughout the year as demand ebbs and flows. As an example, if a company has a cost of goods sold equal to $1 million and average inventory of $500,000, its inventory turnover ratio is 2. That means it turns over inventory twice a year.
16. Receivables Turnover Ratio
Receivables turnover ratio measures how well companies manage their accounts receivable. Specifically, it considers how long it takes companies to collect on outstanding receivables.
Formula:
Receivables Turnover Ratio = Net Annual Credit Sales / Average Accounts Receivable
Example:
If a company has $100,000 in net annual credit sales, for example, and $15,000 in average accounts receivable its receivables turnover ratio is 6.67. The higher the number is, the better, since it indicates the business is more efficient at getting customers to pay up.
Coverage Ratios
Coverage ratios are financial ratios that measure how well a company manages its obligations to suppliers, creditors, and anyone else to whom it owes money. Lenders may use coverage ratios to determine a business’s ability to pay back the money it borrows.
17. Debt Service Coverage Ratio
Debt service coverage reflects whether a company can pay all of its debts, including interest and principal, at any given time. This ratio can offer creditors insight into a company’s cash flow and debt situation.
Formula:
Debt Service Coverage Ratio = Operating Income / Total Debt Service Costs
Example:
A ratio above 1 means the company has more than enough money to meet its debt servicing needs. A ratio equal to 1 means its operating income and debt service costs are the same. A ratio below 1 indicates that the company doesn’t have enough operating income to meet its debt service costs.
18. Interest Coverage Ratio
Interest-coverage ratio is a financial ratio that can tell you whether a company is able to pay interest on its debt obligations on time. This is also called the times earned interest ratio.
Formula:
Interest Coverage Ratio = EBIT ( Earnings Before Interest and Taxes) / Annual Interest Expense
Example:
Let’s say a company has an EBIT of $100,000. Meanwhile, annual interest expense is $25,000. That results in an interest coverage ratio of 4, which means the company has four times more earnings than interest payments.
19. Asset-Coverage Ratio
Asset-coverage ratio measures risk by determining how much of a company’s assets would need to be sold to cover its debts. This can give you an idea of a company’s financial stability overall.
Formula:
Asset Coverage Ratio = (Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt) / Total Debt
You can find all of this information on a company’s balance sheet. The rules for interpreting asset coverage ratio are similar to the ones for debt service coverage ratio.
So a ratio of 1 or higher would suggest the company has sufficient assets to cover its debts. A ratio of 1 would suggest that assets and liabilities are equal. A ratio below 1 means the company doesn’t have enough assets to cover its debts.
Market-Prospect Ratios
Market-prospect ratios make it easier to compare the stock price of a publicly traded company with other financial ratios. These ratios can help analyze trends in stock price movements over time. Earnings per share and price-to-earnings are two examples of market prospect ratios. Investors can also look to dividend payout ratios and dividend yield to judge market prospects.
20. Dividend Payout Ratio
Dividend payout ratio can tell you how much of a company’s net income it pays out to investors as dividends during a specific time period. It’s the balance between the profits passed on to shareholders as dividends and the profits the company keeps.
Formula:
Dividend Payout Ratio = Total Dividends / Net Income
Example:
A company that pays out $1 million in total dividends and has a net income of $5 million has a dividend payout ratio of 0.2. That means 20% of net income goes to shareholders.
21. Dividend Yield
Dividend yield is a financial ratio that tracks how much cash dividends are paid out to common stock shareholders, relative to the market value per share. Investors use this metric to determine how much an investment generates in dividends.
Formula:
Dividend Yield = Cash Dividends Per Share / Market Value Per Share
Example:
For example, a company that pays out $5 in cash dividends per share for shares valued at $50 each are offering investors a dividend yield of 10%.
Ratio Analysis: What Do Financial Ratios Tell You?
Financial statement ratios can be helpful when analyzing stocks. The various formulas included on this financial ratios list offer insight into a company’s profitability, cash flow, debts and assets, all of which can help you form a more complete picture of its overall health. That’s important if you tend to lean toward a fundamental analysis approach for choosing stocks.
Using financial ratios can also give you an idea of how much risk you might be taking on with a particular company, based on how well it manages its financial obligations. You can use these ratios to select companies that align with your risk tolerance and desired return profile.
The Takeaway
Learning the basics of key financial ratios can be a huge help when constructing a stock portfolio. Rather than focusing on a stock’s price, you can use financial ratios to take a closer look under the hood of a company.
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