8 Financial Ratio Analysis Tutorials
Financial ratio analysis turns a company's financial statements into a few simple numbers you can compare. Liquidity ratios ask whether it can pay its bills, profitability ratios ask how well it makes money, and market ratios show what investors pay for those earnings.
What you will learn
- How the current, quick and cash ratios measure short-term liquidity
- What ROA, ROE and profit margin say about profitability
- Why EPS on its own is a weak way to compare companies
- How to read a high or low P/E ratio without jumping to conclusions
- Why a very high ratio is not always good news
The formulas
- Current assets
- Cash, receivables, inventory and other assets expected to turn into cash within 12 months
- Current liabilities
- Debts due within 12 months
- Inventory
- Stock that may take time to sell, so it is left out
- Net income
- Profit after all expenses, interest and taxes
- Total equity
- The owners' stake on the balance sheet
Worked example
A company has current assets of $500 (including $200 of inventory and $100 of cash), current liabilities of $250, total assets of $2,000, equity of $800, sales of $1,500, net income of $120, 60 shares and a share price of $30. Find its key ratios.
- Current ratio = 500 ÷ 250 = 2.0
- Quick ratio = (500 − 200) ÷ 250 = 1.2; cash ratio = 100 ÷ 250 = 0.4
- ROA = 120 ÷ 2,000 = 6%; ROE = 120 ÷ 800 = 15%
- Profit margin = 120 ÷ 1,500 = 8%
- EPS = 120 ÷ 60 = $2; P/E = 30 ÷ 2 = 15
Answer: Current 2.0, quick 1.2, cash 0.4, ROA 6%, ROE 15%, profit margin 8%, EPS $2, P/E 15.
Common questions
What are the main types of financial ratios?
Most textbooks group them into liquidity ratios (current, quick, cash), profitability ratios (ROA, ROE, profit margin), efficiency or turnover ratios, leverage ratios (debt ratio, times interest earned) and market value ratios (EPS, P/E). Each group answers a different question about the business.
What is the difference between the current ratio and the quick ratio?
The current ratio compares all current assets with current liabilities. The quick ratio removes inventory first, because inventory can be slow or hard to turn into cash. So the quick ratio is a stricter test of whether a company can pay its short-term bills.
Is a higher current ratio always better?
No. A higher ratio means creditors face less risk, but a very high one can mean the company is sitting on too much cash or inventory that could be earning a better return elsewhere. Compare it with the industry and with the company's own history.
Is a low P/E ratio good or bad?
It can be either. A low P/E means you pay less for each dollar of earnings, which may signal a bargain. It may also mean investors expect earnings to fall or see extra risk. Always ask why the market is pricing it cheaply.