What is a Financial Ratio?

A financial ratio is a metric used to determine the strength or weakness of a company in certain financial areas. Investors and analysts look at financial ratios to compare two or more companies in the same industry, or to analyze a company's performance over time. A financial ratio is sometimes called an accounting ratio.

Market ratios are used to value a company, or determine its worth as an investment. The most basic of these is the price-to-earnings ratio, also called the P/E ratio. This financial ratio is the price per share of the company's stock divided by earnings per share. Other ways to assess the value of the company include price-to-book, which is the stock price divided by total assets minus intangible assets and liabilities; and price to cash flow, which is the stock price divided by the cash flow per share.

Profit margin is profitability ratio, calculated by dividing net income by revenue. Operating margin, a financial ratio that reflects operating efficiency, is calculated by dividing operating income by net sales. Gross margin is a profitability ratio calculated as revenue minus cost of goods sold, divided by revenue. This is expressed as a percentage, and it measures how much money the company has left after paying for the materials that are used in the goods it produces.

Liquidity ratios show the ratio of a company's assets that can quickly be converted into cash for paying off debt. The current ratio is the basic liquidity ratio, showing how well the company can cover short-term obligations. This is current assets divided by current liabilities. With most transactions on credit, the receivables turnover ratio is an important liquidity ratio that shows how quickly the company collects the money that is owed. This ratio is calculated as net credit sales divided by average accounts receivable.

Activity ratios show how quickly the company's assets can be turned in to sales or cash. The inventory turnover ratio, which is an activity ratio, shows how quickly the company sells its merchandise. It is calculated as the value of inventory divided by sales revenue.

Debt ratios include total debt to total assets, which is the most broad of these ratios. It is calculated by dividing short-term plus long-term debt by total assets. This ratio shows how much of the company's assets were paid for with borrowed money. The interest coverage ratio is a debt ratio that shows a company's ability to pay its debts. This is earnings before interest and taxes (EBIT) divided by total interest payable.

Capital budgeting ratios are ratios that are used by companies to determine the financial feasibility of a proposed project. Net present value, which is the difference between the present value of cash inflows and the present value of cash outflows, is a capital budgeting ratio used for revenue-generating projects. Internal rate of return, which is the rate of growth a project is expected to generate, is often used to compare several different projects under consideration.

For a financial ratio to be valuable, it should be compared with the same ratio for other companies in the industry, or for a single company over time. No single financial ratio will tell the whole story. They do, however, provide a solid basis for comparison when evaluating a company.