If you’re a student trying to make sense of financial statements, you’re not alone! Financial ratios are key tools that simplify complex numbers and help you understand how a company is really doing. In this post, we’ll explore the 5 most important financial ratios every finance student should know. Whether you’re preparing for exams or just starting out in your finance journey, these ratios will give you a solid foundation for analysing any business.
PROFITABILITY RATIOS
- Gross Profit Margin: Measures the percentage of revenue exceeding the cost of goods sold (COGS)
Formula: (Revenue−COGS)/Revenue
- Operating Profit Margin: Indicates the efficiency of a company in controlling production and operational costs
Formula: Operating Income/Revenue
- Net Profit Margin: Shows the percentage of revenue left after all expenses have been deducted
Formula: Net Income/Revenue
- Return on Assets (ROA): Indicates how efficiently assets are used to generate profit
Formula: Net Income/Total Assets
- Return on Equity (ROE): Measures the return generated on shareholders’ equity
Formula: Net Income/Shareholder’s Equity
- Return on Investment (ROI): Assesses the gain or loss generated on an investment relative to its cost
Formula: (Gain from Investment−Cost of Investment)/Cost of Investment
LIQUIDITY RATIOS
- Current Ratio: Measures a company’s ability to pay short-term obligations with short-term assets
Formula: Current Assets/Current Liabilities
- Quick Ratio (Acid Test): Similar to the current ratio but excludes inventory from assets
Formula: (Current Assets−Inventories)/Current Liabilities
- Cash Ratio: Assesses a company’s ability to pay off short-term debt with cash and cash equivalents
Formula: Cash and Cash Equivalents/Current Liabilities
LEVERAGE (DEBT) RATIOS
- Debt to Equity Ratio: Compares a company’s total liabilities to its shareholder equity
Formula: Total Liabilities/Shareholder’s Equity
- Debt to Asset Ratio: Measures the proportion of a company’s assets financed through debt
Formula: Total Debt/Total Assets
- Interest Coverage Ratio: Assesses a company’s ability to pay interest on its outstanding debt
Formula: Earnings Before Interest and Taxes (EBIT)/Interest Expenses
EFFICIENCY RATIOS
- Asset Turnover Ratio: Measures how effectively a company uses its assets to generate revenue
Formula: Revenue/Total Assets
- Inventory Turnover Ratio: Indicates how often inventory is sold and replaced over a period
Formula: COGS/Average Inventory
- Receivables Turnover Ratio: Measures how efficiently a company collects its receivables
Formula: Net Credit Sales/Average Accounts Receivable
MARKET VALUE RATIOS
- Price-to-Earnings Ratio (P/E): Compares a company’s share price to its earnings per share
Formula: Market Value per Share/Earnings per Share (EPS)
- Price/Earnings-to-Growth Ratio (PEG): Compares a company’s PE ration to its earning growth rate
Formula: PE Ratio/Earning growth rate(%)
- Price-to-Book Ratio (P/B): Measures the market’s valuation of a company relative to its book value
Formula: Share Price/Book Value per Share
- Dividend Yield: Shows the dividend income relative to the share price
Formula: Dividend per Share/Price per Share