A financial ratio is the relationship between two numbers obtained from a company's financial statements.
Liquidity ratios measure a company's ability to pay off all of its short-term and long-term obligations.
The current ratio measures a company's ability to pay off all of its short-term obligations with its current assets. If it is less than 1.00, this indicates a higher risk of failed payment.
The quick ratio measures a company's ability to pay its short-term obligations with its liquid assets. It is also called the acid test ratio. In general, a higher quick ratio is preferred.
A higher D/E ratio indicates that the company is mostly financing through borrowing, which can lead to potential risk. However, a D/E ratio lower than 1 does not always promise a lower risk for growing companies especially.
Also called "times interest earned," the interest coverage ratio measures a company's ability to pay its interest expenses with its operating income. An interest coverage ratio greater than 2.5 is considered acceptable risk for an investor.
The asset turnover ratio measures how efficiently a company can generate revenue with its assets. In general, a higher asset turnover ratio is preferred.
The inventory turnover ratio shows the efficiency of a company's use of its inventory and is only helpful when comparing similar companies. A relatively lower ratio indicates weak sales or excess inventory. A higher ratio does not necessarily mean better sales but could be caused by inadequate inventory.
The DSI calculates the average number of days that a company takes to sell its inventory. A high DSI ratio can indicate poorly managed or hard to sell inventory.
The ROE ratio measures the level of efficiency of a company's use of equity to produce profits. The higher the ROE ratio, the better the conversion of equity into profits.
The ROA ratio measures the level of efficiency for a company's use of its assets to produce profits. Generally, ROA ratio is considered good if it is over 5% and excellent if it is over 20%. We should only compare the ROA ratios of firms in the same sector.
The gross profit margin calculates the amount of revenue remaining after paying for the cost of goods sold (COGS). A 20% profit margin is usually considered "good," while a 5% profit margin is considered low.
The price-to-earning ratio is calculated by dividing the firm's stock price by its annual net income per share. P/E ratios are more useful when comparing companies within the same industry. A high P/E ratio is an indicator that a company's stock might be overvalued since its price is relatively high to its earnings.
The dividend yield ratio is calculated by dividing the dividends attributed to shareholders per share by the market value per share. It measures the return on investment in stocks and the company's financial health. Generally, a dividend yield ratio of 30% to 50% is considered healthy, while it could be unsustainable if the number is over 50%.
While financial ratios are widely used in analyzing and evaluating a business, we should be aware of their limitations. No single ratio can tell us the whole picture of a company. Different industries, market capitalization, or operational structures can affect how ratios such as debt to equity or return on equity should be interpreted. No two companies are the same, so it can also be less effective when we are comparing across companies.
The law of one price states that under a free and frictionless market, identical assets should be priced the same globally, regardless of their market or location. It is the main premise behind relative valuation models.
In the context of firm valuations, firms in the same industry that have similar risks, profit margins, and growth prospects may be considered comparable companies.
Typically, several different value multiples are computed for a firm's peers, and this information is then used to compute an implied value for the firm being valued.
Relative valuation models are only one of the many applications of financial ratios. Financial ratios can also help evaluate a company's performance over time or in comparison to its peers across many diverse criteria.