The Five Categories of Financial Ratios
Learn the five major categories of financial ratios and understand when to use each for comprehensive stock analysis.
Learning Objectives
- Identify the five main categories of financial ratios
- Understand the purpose of each ratio category
- Learn when to prioritize different ratio categories
- See how ratio categories work together
The Five Categories of Financial Ratios#
Financial ratios can be organized into five major categories, each designed to answer specific questions about a company. Understanding these categories helps you select the right ratios for any analysis situation.
The five categories of financial ratios are: Valuation, Profitability, Liquidity, Leverage, and Efficiency. Together, they provide a complete picture of a company's worth, performance, and risk.
1. Valuation Ratios: Is the Stock Fairly Priced?#
Valuation ratios compare a company's stock price to its financial performance, helping you determine if a stock is overpriced, underpriced, or fairly valued.
| Ratio | Formula | What It Tells You |
|---|---|---|
| Price-to-Earnings (P/E) | Price / EPS | How much investors pay per dollar of earnings |
| Price-to-Book (P/B) | Price / Book Value | How price compares to net asset value |
| Price-to-Sales (P/S) | Market Cap / Revenue | Valuation relative to sales |
| EV/EBITDA | Enterprise Value / EBITDA | Acquisition value relative to cash earnings |
When to prioritize valuation ratios:
- Deciding whether to buy or sell a stock
- Comparing investment opportunities
- Assessing market expectations
Key Insight
Valuation ratios don't tell you if a company is good—they tell you if the price is right for what you're getting. A great company can be a bad investment if the price is too high.
2. Profitability Ratios: How Well Does the Company Make Money?#
Profitability ratios measure a company's ability to generate profits relative to its revenue, assets, or equity. They reveal operational excellence and competitive advantages.
| Ratio | Formula | What It Tells You |
|---|---|---|
| Gross Margin | Gross Profit / Revenue | Production efficiency |
| Operating Margin | Operating Income / Revenue | Core business profitability |
| Net Margin | Net Income / Revenue | Bottom-line profitability |
| Return on Equity (ROE) | Net Income / Equity | Returns generated for shareholders |
| Return on Assets (ROA) | Net Income / Assets | Asset utilization efficiency |
When to prioritize profitability ratios:
- Evaluating management effectiveness
- Comparing companies within an industry
- Assessing competitive advantages
- Predicting future earnings potential
3. Liquidity Ratios: Can the Company Pay Its Bills?#
Liquidity ratios assess a company's ability to meet short-term obligations. They're critical for evaluating financial stability and near-term survival.
| Ratio | Formula | What It Tells You |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Ability to cover short-term debts |
| Quick Ratio | (Cash + Receivables) / Current Liabilities | Immediate payment ability |
| Cash Ratio | Cash / Current Liabilities | Most conservative liquidity measure |
When to prioritize liquidity ratios:
- Analyzing companies in financial distress
- Evaluating cyclical businesses before downturns
- Assessing ability to weather economic shocks
- Reviewing companies with high debt loads
Liquidity Red Flags
A current ratio below 1.0 means a company has more short-term debts than short-term assets—a potential danger sign. However, some industries (like grocery) operate successfully with lower ratios due to rapid inventory turnover.
4. Leverage Ratios: How Much Debt Does the Company Carry?#
Leverage (solvency) ratios measure a company's use of debt financing and its ability to service that debt. They reveal long-term financial risk.
| Ratio | Formula | What It Tells You |
|---|---|---|
| Debt-to-Equity | Total Debt / Equity | Capital structure and risk |
| Debt-to-Assets | Total Debt / Assets | Portion of assets financed by debt |
| Interest Coverage | EBIT / Interest Expense | Ability to pay interest |
| Debt-to-EBITDA | Total Debt / EBITDA | Years to pay off debt |
When to prioritize leverage ratios:
- Evaluating bankruptcy risk
- Comparing capital structures
- Assessing impact of rising interest rates
- Analyzing companies with significant debt
5. Efficiency Ratios: How Well Does the Company Use Its Resources?#
Efficiency (activity) ratios measure how effectively a company uses its assets and manages its operations. They reveal operational excellence.
| Ratio | Formula | What It Tells You |
|---|---|---|
| Asset Turnover | Revenue / Assets | How efficiently assets generate sales |
| Inventory Turnover | COGS / Inventory | How quickly inventory sells |
| Receivables Turnover | Revenue / Receivables | How quickly customers pay |
| Cash Conversion Cycle | DIO + DSO - DPO | Days to convert inventory to cash |
When to prioritize efficiency ratios:
- Analyzing retailers and manufacturers
- Evaluating working capital management
- Comparing operational effectiveness
- Identifying potential cash flow issues
How the Categories Work Together#
Each ratio category answers different questions. A complete analysis requires using ratios from multiple categories:
| Question | Primary Category | Supporting Categories |
|---|---|---|
| Should I buy this stock? | Valuation | Profitability, Efficiency |
| Is the company well-managed? | Profitability | Efficiency, Leverage |
| Is the company financially safe? | Liquidity | Leverage, Profitability |
| Can the company grow sustainably? | Efficiency | Profitability, Leverage |
Example: Analyzing a Retail Stock#
Let's say you're analyzing Walmart. Here's how you might prioritize ratios:
- Valuation: P/E and EV/EBITDA to see if the price is reasonable
- Profitability: Operating margin to assess competitive position
- Efficiency: Inventory turnover (critical for retailers)
- Liquidity: Current ratio for short-term health
- Leverage: Debt-to-EBITDA for long-term stability
Industry Matters
Different industries emphasize different ratio categories. Banks focus heavily on leverage ratios. Retailers prioritize efficiency. Tech companies often lead with profitability. Know your industry's key ratios.
Ratio Interconnections#
Ratios don't exist in isolation. They're connected through the DuPont framework, which shows how profitability, efficiency, and leverage combine:
ROE = Net Margin × Asset Turnover × Financial Leverage
This formula reveals that a company can achieve high ROE through:
- High profitability (margins)
- High efficiency (turnover)
- High leverage (debt)—though this adds risk
Understanding these connections helps you interpret ratios in context and spot potential issues.
Key Takeaways
- The five ratio categories are: Valuation, Profitability, Liquidity, Leverage, and Efficiency
- Valuation ratios assess whether price is fair; Profitability ratios measure earning power
- Liquidity ratios evaluate short-term safety; Leverage ratios assess long-term risk
- Efficiency ratios reveal operational effectiveness
- Complete analysis requires ratios from multiple categories working together
- Different industries emphasize different ratio categories