Key Financial Ratios#

Financial ratios transform raw numbers into comparable metrics. They help you understand performance, spot trends, and compare companies—even those of different sizes.

Ratios are tools, not answers. A ratio tells you something is happening but not always why. Use ratios to identify areas for deeper investigation.

Profitability Ratios#

These measure how efficiently the company generates profits.

Margin Ratios#

Ratio	Formula	What It Shows
Gross Margin	Gross Profit ÷ Revenue	Profitability of products/services
Operating Margin	Operating Income ÷ Revenue	Efficiency of core operations
Net Profit Margin	Net Income ÷ Revenue	Overall profitability

Example:

Revenue: $1,000,000
Gross Profit: $400,000 → Gross Margin: 40%
Operating Income: $150,000 → Operating Margin: 15%
Net Income: $100,000 → Net Profit Margin: 10%

Margin Progression

Watch how margins progress from gross to net. A large drop between operating margin and net margin might indicate high interest costs (debt burden).

Return Ratios#

Ratio	Formula	What It Shows
Return on Equity (ROE)	Net Income ÷ Shareholders' Equity	Return generated on shareholder investment
Return on Assets (ROA)	Net Income ÷ Total Assets	How efficiently assets generate profit
Return on Invested Capital (ROIC)	NOPAT ÷ Invested Capital	Return on all capital (debt + equity)

ROE Benchmarks:

Below 10%: Below average
10-15%: Decent
15-20%: Good
Above 20%: Excellent (verify sustainability)

ROE Caution

High ROE can result from high leverage (debt), not operational excellence. Always check debt levels alongside ROE.

DuPont Analysis#

Break down ROE into its components:

DuPont Analysis

ROE = \text{Net Margin} \times \text{Asset Turnover} \times \text{Equity Multiplier}

Where

Net Margin=Net Income / Revenue (Profitability)

Asset Turnover=Revenue / Assets (Efficiency)

Equity Multiplier=Assets / Equity (Leverage)

Component	Formula	What It Measures
Net Margin	Net Income ÷ Revenue	Profitability
Asset Turnover	Revenue ÷ Assets	Efficiency
Equity Multiplier	Assets ÷ Equity	Leverage

This reveals whether ROE comes from profitability, efficiency, or leverage.

Liquidity Ratios#

These measure short-term ability to pay obligations.

Current Ratio#

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Ratio	Interpretation
Below 1.0	May struggle to pay short-term bills
1.0 - 1.5	Adequate (industry dependent)
1.5 - 2.0	Good liquidity cushion
Above 3.0	May have too much idle capital

Quick Ratio (Acid Test)#

Quick Ratio (Acid Test)

\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

More conservative—excludes inventory which may be hard to sell quickly.

Ratio	Interpretation
Below 0.5	Potential liquidity stress
0.5 - 1.0	Acceptable for many industries
Above 1.0	Strong short-term position

Cash Ratio#

\text{Cash Ratio} = \frac{\text{Cash}}{\text{Current Liabilities}}

Most conservative—only counts cash.

Leverage Ratios#

These measure financial risk from debt.

Debt-to-Equity#

Debt-to-Equity Ratio

D/E = \frac{\text{Total Debt}}{\text{Shareholders' Equity}}

Ratio	Interpretation
Below 0.5	Conservative
0.5 - 1.0	Moderate
1.0 - 2.0	Higher leverage
Above 2.0	Highly leveraged

Note: Acceptable levels vary significantly by industry.

Debt-to-EBITDA#

\text{Debt-to-EBITDA} = \frac{\text{Total Debt}}{EBITDA}

Shows how many years of earnings needed to pay off debt.

Ratio	Interpretation
Below 2x	Low leverage
2-3x	Moderate
3-4x	Elevated
Above 4x	High risk

Interest Coverage#

Interest Coverage Ratio

\text{Interest Coverage} = \frac{EBIT}{\text{Interest Expense}}

Ratio	Interpretation
Below 1.5	Danger zone
1.5 - 3.0	Watch carefully
3.0 - 5.0	Comfortable
Above 5.0	Well covered

Coverage Crisis

Interest coverage below 1.5 means the company is struggling to cover interest payments from operations—a serious warning sign.

Efficiency Ratios#

These measure how well the company uses its resources.

Asset Turnover#

\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Average Total Assets}}

Higher means more revenue generated per dollar of assets.

Inventory Turnover#

\text{Inventory Turnover} = \frac{COGS}{\text{Average Inventory}}

Turnover	Days in Inventory	Interpretation
12x	~30 days	Fast-moving inventory
6x	~60 days	Moderate
4x	~90 days	Slow
2x	~180 days	Concern—may become obsolete

Receivables Turnover#

\text{Receivables Turnover} = \frac{\text{Revenue}}{\text{Average Receivables}}

DSO = \frac{365}{\text{Receivables Turnover}}

DSO	Interpretation
< 30 days	Very fast collection
30-45 days	Typical for many industries
45-60 days	Slower—monitor
> 60 days	Investigate collection issues

Using Ratios Effectively#

Compare Over Time#

Track ratios across multiple periods:

Ratio	2022	2023	2024	Trend
Net Margin	12%	11%	9%	Declining ⚠️
Current Ratio	1.5	1.8	2.0	Improving ✓
D/E	0.6	0.8	1.2	Rising ⚠️

Compare to Peers#

Ratios mean little in isolation. Compare to:

Industry averages
Direct competitors
Company's own history

Watch for Anomalies#

Pattern	Investigate
Sudden ratio change	What caused it?
Ratio far from peers	Is the company different or troubled?
Ratios tell conflicting stories	Which is more accurate?

Ratio Checklist

Quick health check: Current ratio > 1.5, D/E < 1.0, Interest coverage > 3.0, ROE > 15%, margins stable or improving. A company passing all these is likely financially solid.

Key Takeaways

Profitability ratios (margins, ROE, ROA) measure profit generation
Liquidity ratios (current, quick) measure ability to pay short-term bills
Leverage ratios (D/E, interest coverage) measure financial risk
Efficiency ratios (turnover) measure resource utilization
Compare ratios over time and against peers
Use DuPont analysis to understand what drives ROE
No single ratio tells the whole story—use them together