Financial Ratios
Financial ratios convert raw numbers from financial statements into meaningful comparisons. Used to assess financial health, compare firms to industry peers, and track performance over time. Ratios fall into three major classifications, plus valuation ratios used in investment analysis.
graph TD FR[Financial Ratios] --> S[Solvency Ratios Estimate financial risk] FR --> P[Profitability Ratios Measure earnings potential] FR --> A[Activity Ratios Evaluate use of assets] S --> ST[Short-Term: Current Ratio · Quick Ratio] S --> LT[Long-Term: Debt-to-Equity · Debt Ratio Times Interest Earned] P --> PR[ROE · EPS · Return on Sales Gross/Net Profit Margin Return on Assets] A --> AR[Inventory Turnover Avg Collection Period Total Assets Turnover]
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How It Appears Per Course
ADMN 201
Ratios are most useful for comparison — against the same firm’s historical data, or against industry peers. A single ratio in isolation tells you little.
Solvency Ratios — Estimating Financial Risk
Short-Term Solvency (Liquidity)
| Ratio | Formula | What it tells you |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Can the firm pay current debts out of current assets? |
| Quick Ratio | (Current Assets − Inventory) / Current Liabilities | Same, but excludes inventory (least liquid current asset) |
Long-Term Solvency (Leverage)
| Ratio | Formula | What it tells you |
|---|---|---|
| Debt-to-Equity Ratio | Total Liabilities / Owners’ Equity | How much debt is used relative to equity |
| Debt Ratio | Total Liabilities / Total Assets | What % of assets are financed by debt |
| Times Interest Earned | Operating Income / Net Interest Expense | Can the firm cover interest from operating profit? Higher = stronger |
Leverage = using borrowed funds to increase purchasing power and potential return — but also risk of loss.
Profitability Ratios — Measuring Earnings Potential
| Ratio | Formula | What it tells you |
|---|---|---|
| Gross Profit Margin | Gross Profit / Sales | % of revenue remaining after COGS; measures production efficiency |
| Net Profit Margin | Net Income / Sales | % of each revenue dollar remaining after all costs |
| Return on Sales | Net Income / Sales Revenue | Same as Net Profit Margin |
| Return on Equity (ROE) | Net Income / Owners’ Equity | Profit generated per dollar of shareholder equity |
| Return on Total Assets | Net Income / Total Assets | How efficiently all assets generate profit |
| Earnings Per Share (EPS) | Net Income / Shares Outstanding | Profit allocated to each common share |
Activity Ratios — Evaluating Management’s Use of Assets
| Ratio | Formula | What it tells you |
|---|---|---|
| Inventory Turnover Ratio | COGS / Average Inventory | Times inventory sold and restocked per year; higher = more efficient |
| Average Collection Period | Accounts Receivable / (Net Sales / 365) | Days to collect payment from customers; lower = faster |
| Total Assets Turnover | Net Sales / Total Assets | Times total assets turn over relative to sales |
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Valuation Ratios — Investment Analysis
| Ratio | Formula | What it tells you |
|---|---|---|
| Price/Earnings (P/E) | Stock Price / EPS | What the market pays per dollar of earnings |
| Book Value per Share | Total Stockholders’ Equity / Shares | Accounting value per share |
| Market/Book (M/B) | Market Price per Share / Book Value per Share | Market value vs. accounting value |
A high P/E signals investors expect strong future growth.
A low P/E may indicate a mature/slow-growth company or an undervalued stock.
P/E is most useful when comparing companies within the same industry.
EPS and P/E Example:
- Net Income: ,000,000 | Shares: 1,000,000 → **EPS = **
- Stock Price: → P/E = 10 (market pays per of earnings)
Cross-Course Connections
AccountingEquation-FinancialStatements — ratios are calculated from balance sheet and income statement figures
LongTermFinancing — debt ratios reflect capital structure decisions
SecuritiesMarkets — P/E and M/B ratios used by investors in stock analysis
FinancialManager — financial managers use ratios for control and benchmarking
Key Points for Exam
- Three categories: Solvency (risk), Profitability (earnings), Activity (efficiency)
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Current Assets − Inventory) / Current Liabilities
- Debt-to-Equity = Total Liabilities / Owners’ Equity
- Debt Ratio = Total Liabilities / Total Assets
- Times Interest Earned = Operating Income / Net Interest Expense
- Gross Profit Margin = Gross Profit / Sales
- Net Profit Margin = Net Income / Sales
- ROE = Net Income / Owners’ Equity
- EPS = Net Income / Shares Outstanding
- P/E = Stock Price / EPS (compare within same industry only)
- Inventory Turnover = COGS / Average Inventory
- Average Collection Period = Accounts Receivable / (Net Sales / 365)
- Gross Profit = Revenue − COGS
Cross-course: DataVisualization-FinancialRatios — PHIL 252 visualization tools for detecting misleading financial charts and cherry-picked ratio comparisons