What are financial ratios?
Financial ratios compare numbers from the balance sheet and income statement to show how a company is doing. They fall into four groups:
- Liquidity: can it pay its short-term bills?
- Leverage: how much of it is financed by debt?
- Profitability: how much profit does it make?
- Efficiency: how well does it use its assets?
Key formulas
Worked example
With the sample numbers above: current ratio = $120,000 ÷ $60,000 = 2.00. Quick ratio = ($120,000 − $30,000) ÷ $60,000 = 1.50. Net profit margin = $50,000 ÷ $500,000 = 10%. ROE = $50,000 ÷ $240,000 = 20.8%. Inventory turnover = $300,000 ÷ $30,000 = 10 times, or 36.5 days.
Frequently asked questions
What is a good current ratio?
It depends on the industry, but a current ratio between about 1.2 and 2 is often seen as healthy. Below 1 means current liabilities exceed current assets.
What is the difference between the current ratio and the quick ratio?
The quick ratio leaves out inventory (and prepaid expenses), because inventory can take time to turn into cash. It is a stricter test of liquidity.
Should I use average or ending balances?
Ratios that compare an income statement amount with a balance sheet amount, like ROA, ROE and inventory turnover, are usually calculated with average balances. If your question gives only ending balances, use those.
What is the difference between ROA and ROE?
ROA measures profit against everything the company owns. ROE measures profit against only the owners' investment, so debt makes ROE higher than ROA.