Financial Ratios
Calculated relationships between financial statement items, providing insights into liquidity, profitability, leverage, and operational efficiency for performance evaluation.
Financial Ratios
Calculated relationships between various financial statement items that provide insights into a company’s liquidity, profitability, leverage, operational efficiency, and market valuation.
For instance, common financial ratios include:
- Liquidity: Current ratio (current assets ÷ current liabilities) of 2.0 indicates strong short-term solvency
- Profitability: Return on assets (net income ÷ average total assets) of 8% shows how efficiently assets generate earnings
- Leverage: Debt-to-equity ratio (total debt ÷ total equity) of 0.5 reflects conservative financing with twice as much equity as debt
- Efficiency: Inventory turnover (cost of goods sold ÷ average inventory) of 12 suggests inventory turns once monthly
- Valuation: Price-to-earnings ratio (share price ÷ earnings per share) of 15 indicates investors pay $15 for each $1 of earnings
Financial ratios standardize data to facilitate comparisons across time periods, companies, and industries. They serve multiple purposes: management uses them to identify strengths and weaknesses, lenders evaluate creditworthiness, investors assess investment potential, and analysts forecast future performance. While providing valuable analytical shortcuts, ratios should be interpreted considering industry norms, business strategies, accounting methods, and economic conditions.