Financial Ratios Glossary

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Understanding the key financial metrics that reveal a company's health, efficiency, and value. Each ratio tells a different part of the story.

Profitability Ratios

Net Profit Margin

What It Measures

How much profit a company keeps from every dollar of revenue after all expenses, taxes, and interest. It's the ultimate measure of profitability—what's left for shareholders.

Formula

Net Profit Margin = (Net Income ÷ Revenue) × 100

Net Income = Revenue minus all costs, operating expenses, interest, and taxes

Why It Matters

Shows efficiency at converting sales into actual profit. High margins mean pricing power or low costs. Compare across competitors to see who manages expenses best.

Interpreting the Numbers

Good

> 15%

Strong pricing power, efficient operations

5% – 15%

Average for most industries

Poor

< 5%

Thin margins, high competition

EBITDA Margin

What It Measures

Operating profitability before accounting for interest, taxes, depreciation, and amortization. Shows how profitable core operations are, ignoring financing and accounting decisions.

Formula

EBITDA Margin = (EBITDA ÷ Revenue) × 100

EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization

Why It Matters

Useful for comparing companies with different capital structures or tax situations. Focuses purely on operational efficiency without accounting noise.

Interpreting the Numbers

Good

> 20%

Highly efficient operations

10% – 20%

Moderate operational profitability

Poor

< 10%

Struggling with operational costs

Return on Equity (ROE)

What It Measures

How much profit a company generates with the money shareholders have invested. It's the return shareholders get on their equity stake.

Formula

ROE = (Net Income ÷ Shareholders' Equity) × 100

Shareholders' Equity = Total Assets minus Total Liabilities (book value)

Why It Matters

Shows management's effectiveness at using investor capital to create profit. Higher ROE means better returns for shareholders—but watch for excessive debt inflating the number.

Interpreting the Numbers

Good

> 15%

Excellent use of shareholder capital

10% – 15%

Acceptable returns for investors

Poor

< 10%

Underperforming, capital misallocation

Return on Assets (ROA)

What It Measures

How efficiently a company uses its total assets to generate profit. It shows whether management is squeezing profit out of every dollar of assets.

Formula

ROA = (Net Income ÷ Total Assets) × 100

Total Assets = Everything the company owns (cash, inventory, property, equipment, etc.)

Why It Matters

Reveals asset efficiency. Capital-light businesses (software) typically have higher ROA than asset-heavy ones (manufacturing). Compare within the same industry.

Interpreting the Numbers

Good

> 10%

Efficient asset utilization

5% – 10%

Average asset productivity

Poor

< 5%

Underutilized or bloated assets

Liquidity Ratios

Current Ratio

What It Measures

A company's ability to pay short-term obligations (due within 1 year) using short-term assets. It's a measure of liquidity and financial health.

Formula

Current Ratio = Current Assets ÷ Current Liabilities

Current Assets = Cash, receivables, inventory. Current Liabilities = Debt and payables due within 1 year.

Why It Matters

Tells you if a company can cover its near-term bills. A ratio below 1 signals potential cash flow trouble. Too high (>3) may mean excess cash not being invested productively.

Interpreting the Numbers

Good

1.5 – 3.0

Healthy cushion for obligations

1.0 – 1.5

Adequate but tight

Poor

< 1.0

Risk of default on short-term debt

Quick Ratio (Acid-Test Ratio)

What It Measures

Like the current ratio, but stricter—excludes inventory since it may not convert to cash quickly. Tests if a company can pay bills with its most liquid assets.

Formula

Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities

Focuses on cash, marketable securities, and receivables only

Why It Matters

More conservative test of liquidity. Important for companies with slow-moving inventory. A quick ratio >1 means liquid assets exceed short-term debts.

Interpreting the Numbers

Good

> 1.0

Can pay bills without selling inventory

0.8 – 1.0

Manageable if cash flow is steady

Poor

< 0.8

May struggle with immediate debts

Leverage Ratios

Debt-to-Equity Ratio

What It Measures

How much debt a company uses relative to shareholder equity. Shows financial leverage and risk—higher debt means higher fixed costs and risk.

Formula

Debt-to-Equity = Total Liabilities ÷ Shareholders' Equity

Total Liabilities = All debt (short-term + long-term). Equity = Book value owned by shareholders.

Why It Matters

Shows capital structure risk. High leverage amplifies returns in good times but magnifies losses in downturns. Compare within industry—utilities can handle more debt than tech startups.

Interpreting the Numbers

Good

< 1.0

More equity than debt, low risk

1.0 – 2.0

Moderate leverage, typical for many firms

Poor

> 2.0

High debt burden, financial stress risk

Interest Coverage Ratio

What It Measures

How easily a company can pay interest on its debt using operating earnings (EBIT). Higher values mean safer debt payments.

Formula

Interest Coverage = EBIT ÷ Interest Expense

EBIT = Earnings Before Interest and Taxes (operating profit)

Why It Matters

Tells whether a company can afford its debt. A ratio below 1.5 suggests earnings barely cover interest—risky. Above 3 means comfortable cushion.

Interpreting the Numbers

Good

> 3.0

Strong ability to service debt

1.5 – 3.0

Adequate but vulnerable to downturns

Poor

< 1.5

Struggling to cover interest payments

Efficiency Ratios

Asset Turnover

What It Measures

How efficiently a company uses its assets to generate revenue. Higher turnover means more sales per dollar of assets.

Formula

Asset Turnover = Revenue ÷ Total Assets

Measures how many dollars of revenue each dollar of assets produces

Why It Matters

Shows operational efficiency. Retailers typically have high turnover (inventory moves fast), while utilities have low turnover (heavy infrastructure). Compare within industry.

Interpreting the Numbers

Good

> 1.5

Efficient asset utilization

0.5 – 1.5

Varies widely by industry

Poor

< 0.5

Underutilized or bloated asset base

Inventory Turnover

What It Measures

How many times a company sells and replaces inventory during a period. Shows inventory management efficiency and demand strength.

Formula

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Higher ratio = inventory moves quickly. Lower = slow sales or overstocking.

Why It Matters

Critical for retailers and manufacturers. High turnover means strong demand and efficient inventory management. Low turnover may signal obsolete products or weak sales.

Interpreting the Numbers

Good

> 8

Fast-moving inventory, strong demand

4 – 8

Average for most industries

Poor

< 4

Slow sales, potential obsolescence

Valuation Ratios

Price-to-Earnings (P/E) Ratio

What It Measures

How much investors are willing to pay for each dollar of earnings. It's the most common valuation metric—shows market expectations.

Formula

P/E Ratio = Share Price ÷ Earnings Per Share

Also: Market Cap ÷ Net Income. Uses trailing (TTM) or forward earnings.

Why It Matters

High P/E suggests growth expectations or overvaluation. Low P/E may signal undervaluation or pessimism. Compare to industry peers and historical averages.

Interpreting the Numbers

Growth

> 25

High growth expectations (tech, biotech)

Fair Value

15 – 25

Average for S&P 500

Value

< 15

Undervalued or low growth expectations

Price-to-Book (P/B) Ratio

What It Measures

How much investors pay for each dollar of net assets (book value). Compares market value to accounting value.

Formula

P/B Ratio = Share Price ÷ Book Value Per Share

Book Value = Shareholders' Equity (assets minus liabilities)

Why It Matters

Useful for asset-heavy companies (banks, real estate). P/B below 1 means the stock trades below book value—potential bargain. Less relevant for tech/service companies with few tangible assets.

Interpreting the Numbers

Premium

> 3.0

High growth or intangible value

Fair

1.0 – 3.0

Typical for mature companies

Discount

< 1.0

Below book value, potential value

PEG Ratio

What It Measures

P/E ratio adjusted for earnings growth rate. Helps determine if a high P/E is justified by growth prospects.

Formula

PEG Ratio = (P/E Ratio) ÷ (Annual EPS Growth Rate)

Growth rate typically uses projected 3-5 year EPS growth

Why It Matters

A PEG of 1 suggests the P/E fairly reflects growth. Below 1 may indicate undervaluation, above 1 could mean overvaluation. More useful for growth stocks than mature companies.

Interpreting the Numbers

Undervalued

< 1.0

Growth not fully priced in

Fair

1.0 – 1.5

Fairly valued relative to growth

Overvalued

> 2.0

Expensive relative to growth rate

Dividend Yield

What It Measures

The annual dividend payment as a percentage of the stock price. Shows the cash income return investors receive.

Formula

Dividend Yield = (Annual Dividends Per Share ÷ Share Price) × 100

Expressed as a percentage. Fluctuates with stock price changes.

Why It Matters

Important for income investors. High yields may signal value or a struggling company. Compare to bond yields and sector averages. Steady dividend growth is a sign of financial health.

Interpreting the Numbers

High Yield

> 4%

Attractive income, check sustainability

Moderate

2% – 4%

Balanced income and growth

Low/None

< 2%

Growth focus, reinvesting profits