Ratios are a simple but powerful tool in the financial analyst’s toolbox.
A ratio indicates how many times one number (X) contains another number (Y) and is calculated by dividing X by Y. Financial ratios can therefore be drawn out of any two line-items from a firm’s financial statements by dividing one item by the other. Many internal and external stakeholders, such as investors, analysts, firms’ management, and creditors use it as a means of performance evaluation. In fact, there is a set of exceptionally informative ratios (also known as multiples), widely used in financial analysis, and basically mandatory in any financial model.
What Are the Five Major Categories of Financial Ratios?
Broadly speaking, there are five groups of ratios, each looking at a business from a different perspective:
Profitability ratios reflect how profitable or unprofitable a company is and, when viewed as a group, can also be informative of the company’s cost structure. A firm’s ability to generate profits might be measured on several “levels”. Ratios that normally fall into that group are:
- Gross profit margin
- Operating profit margin
- Pre-tax margin
- Net profit margin
Activity ratios evaluate the efficiency of a company in terms of managing its normal business operations. They also form the basis of any cash management system.
Important activity (also called efficiency) ratios are the following:
- Receivables turnover
- Payables turnover
- Working capital turnover
- Inventory turnover
- Days of sales outstanding
- Days of payables
- Days of inventory on hand
- Cash conversion cycle
Liquidity ratios gauge how exposed the company is to short-term liquidity problems. This group encompasses:
- Current ratio
- Quick ratio
- Cash ratio
- Defensive interval
Solvency ratios consider whether the company has the ability to meet its long-term obligations. The most important solvency multiples are:
- Interest coverage
- Fixed-charge coverage
- Financial leverage
Valuation ratios measure the intrinsic value of the company and its owners’ equity. The most important valuation ratios are:
- Earnings per share (EPS)
- Price-earnings ratio (P/E)
- Dividend yield
- Retention rate
- Dividend payout ratio
Barring a few exceptions, most ratios are not very useful as standalone measures. The real value of ratio analysis lies in comparing various multiples across companies, with industry averages, and over time. Ratios are also invaluable as inputs in financial modeling.
To gain a better understanding of the mechanics behind ratio analysis, we recommend you review all five ratio groups separately.
Download a free Financial Ratios Cheat Sheet, where you’ll find the most common financial ratios with formulas and interpretation.