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.
Financial ratio analysis explained simply
Financial ratios turn financial statements into a few numbers you can compare. Liquidity ratios (current, quick, cash) ask whether a company can pay its bills, profitability ratios (ROA, ROE, profit margin) ask how well it makes money, and market ratios (EPS, P/E) show what investors pay for its earnings. In the example: current ratio 2.0, ROE 15%, P/E 15.
What this financial ratios lesson covers
- 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
Financial ratio formulas, explained
- 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
How to calculate financial ratios step by step (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.
Liquidity vs profitability vs market ratios
| Liquidity ratios | Profitability ratios | Market ratios | |
|---|---|---|---|
| Question it answers | Can it pay its short-term bills? | How well does it make money? | What do investors pay for its earnings? |
| Examples | Current, quick, cash | ROA, ROE, profit margin | EPS, P/E |
| In the example | Current 2.0, quick 1.2, cash 0.4 | ROA 6%, ROE 15%, margin 8% | EPS $2, P/E 15 |
| Watch out for | Inventory or receivables that won't turn into cash | ROE pushed up by heavy debt | A low P/E that reflects real trouble |
Can you trust a ratio? David's take
A current ratio of 2.0 looks safe. That's the official fact. The de facto facts are whether the $200 of inventory will actually sell and whether customers will actually pay. My concept 'High IQ, Wrong Variables' says smart people can reason brilliantly with the variables they're given but be poor at choosing which ones matter, and at spotting which ones are being misread: official facts versus de facto facts. A ratio is only as good as the numbers inside it. Before you trust one, ask what it's really made of.
From David's concept: High IQ, Wrong Variables. This is David's opinion, alongside the standard textbook answer above.
Harder financial ratio questions
Can a company with a current ratio of 2.0 still run out of cash?
Yes. In the example, only $100 of the $500 in current assets is cash, against $250 due within the year (cash ratio 0.4). If the inventory sells slowly or customers pay late, the company can still miss payments. That's why analysts look at the quick and cash ratios too.
Why can ROE look great when a company is weak?
ROE = profit margin × asset turnover × equity multiplier (the DuPont breakdown). In the example, 8% × 0.75 × 2.5 = 15%. A high ROE driven by the equity multiplier comes from debt, not from running the business better, so it carries more risk. Losses or big buybacks that shrink equity can also inflate ROE.
Can you compare ratios across different industries?
Only with care. A supermarket typically has thin margins and fast turnover, while a software firm has high margins and slow-moving assets. Compare a company with its own past and with close competitors rather than against one universal 'good' number.
Common financial ratio 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.