Most Important Financial Ratios

Top 5 Financial Ratios

Financial ratios are a tool used to evaluate a company's financial performance by comparing various aspects of its financial statements. They are used to measure a company's liquidity, profitability, solvency, efficiency, and investment performance. By comparing different financial ratios, stakeholders such as investors, lenders, and management can gain a better understanding of a company's overall financial health and make informed decisions.

The most common and top five ratios used in the financial field include:

1. Debt-to-Equity Ratio

The debt-to-equity ratio, is a quantification of a firm’s financial leverage estimated by dividing the total liabilities by stockholders’ equity. This ratio indicates the proportion of equity and debt used by the company to finance its assets.

The debt-to-equity ratio is important because it measures a company's financial leverage, or how much debt the company has relative to its equity. A high debt-to-equity ratio can indicate that a company is taking on too much debt and may be at a higher risk of defaulting on its loans. On the other hand, a low debt-to-equity ratio can indicate that a company is financially conservative and may have more room to take on debt in the future.

In addition, a high debt-to-equity ratio can affect a company's credit rating, which in turn can affect the company's ability to borrow money at favorable interest rates. Lenders and investors often use the debt-to-equity ratio as a measure of a company's financial risk, so a high ratio can make it more difficult for a company to secure financing.

It's also important to note that different industries have different typical debt-to-equity ratios, and it's important to compare a company's ratio to the industry average.

The formula used to compute this ratio is

Total Liabilities / Shareholders Equity

2. Current Ratio

The current ratio is a liquidity ratio that estimates a company's ability to meet short-term obligations. The current ratio is important because it measures a company's ability to pay its short-term obligations, such as bills and loans due within the next 12 months.  The formula used to calculate current ratio is:

Current Assets / Current Liabilities

A current ratio of 1 or higher is generally considered healthy because it indicates that the company has enough current assets to cover its short-term liabilities. A ratio below 1 may indicate that the company may have difficulty meeting its short-term financial obligations.

Lenders and investors often use the current ratio as a measure of a company's short-term liquidity, or its ability to meet its financial obligations in the short term. A high current ratio may indicate that a company is financially sound and has enough assets to cover its debts, while a low ratio may indicate financial difficulties. It's also important to compare a company's current ratio to the industry average, since different industries have different typical current ratios.

3. Quick Ratio

The quick ratio, also known as the "acid test ratio" or "quick assets ratio", is a measure of a company's short-term liquidity. The quick ratio is helpful in measuring a company's short-term liabilities against its most liquid assets.

The formula used for computing quick ratio is:

(Current Assets – Inventories)/ Current Liabilities

A higher quick ratio indicates the better position of a company.

The quick ratio is considered a more conservative measure of liquidity than the current ratio because it excludes inventory, which can be difficult to convert into cash quickly. A company with a high current ratio but a low quick ratio may have a lot of inventory that it would have difficulty selling quickly, so it's important to look at both ratios to get a complete picture of a company's liquidity.

4. Return on Equity (ROE)

The return on equity is the amount of net income returned as a percentage of shareholders equity. Moreover, the return on equity estimates the profitability of a corporation by revealing the amount of profit generated by a company with the money invested by the shareholders. Also, the return on equity ratio is expressed as a percentage and is computed as:

Net Income/Shareholder's Equity

Return on Equity (ROE) is a measure of a company's profitability by comparing net income to shareholders' equity.  A positive ROE indicates that a company is making a profit for its shareholders, while a negative ROE indicates that a company is losing money. It's possible for a company to have a negative ROE if its net income is negative. This can happen if a company does not generate enough revenue to cover its expenses, or if it takes on large amounts of debt or loses money on investments. 

A negative ROE can be a warning sign for investors because it indicates that a company is not earning a return on the money that shareholders have invested in the company. It's important to note that a negative ROE doesn't always mean poor performance. A company that is investing heavily in growth, research and development, or restructuring may have a negative ROE in the short term, but a positive ROE in the long term.

Also, as with other ratios, it's important to compare a company's ROE to the industry average and the company's historical performance to get a better idea of the company's profitability.

The return on equity ratio is also referred as “return on net worth” (RONW).

5. Net Profit Margin

The net profit margin is a figure that indicates a company's efficiency in controlling costs. A higher net profit margin indicates that the company is more efficient at converting its revenues into actual profits. This ratio is a good way to make comparisons between companies in the same industry, as such companies are often subject to similar business conditions.

The formula for computing the Net Profit Margin is:

Net Profit / Net Sales 

This ratio is interesting for a variety of stakeholders, including:

• Investors: The net profit margin is a key indicator of a company's profitability and can be used to compare a company's performance with that of its peers. A high net profit margin can indicate that a company is efficiently managing its expenses and is more likely to generate returns for shareholders.

• Management: The net profit margin can be used to help management identify areas of the business where costs can be reduced and revenue can be increased.

• Lenders: Lenders may use the net profit margin as a measure of a company's ability to generate enough income to repay loans.

• Competitors: The net profit margin can also be used to compare a company's performance with its competitors. By comparing net profit margins, a company can identify areas where it is outperforming or underperforming its competitors.

It's important to note that different industries have different typical net profit margins and it's important to compare a company's net profit margin with the industry average.

We calculated average ratios based on SEC data for our readers – see industry benchmarking.