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W25399

A NOTE ON FINANCIAL RATIOS: A BEGINNER’S GUIDE

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Janey Zhang wrote this note under the supervision of Professor Zhichuan (Frank) Li solely to provide material for class discussion.
The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised
certain names and other identifying information to protect confidentiality.

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Copyright © 2021, Ivey Business School Foundation Version: 2021-08-17

After a full body checkup, your doctor will provide you with a list of test results. If some of the numbers
on the list fall outside the normal range, the doctor will provide a diagnosis and make treatment suggestions.
In a similar manner, financial ratios provide a list of test results to assess a company’s financial health.
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Financial ratios are calculated based on the numbers found on a company’s financial statements – that is,
balance sheets, income statements, and cash flow statements. External users of financial ratios include
financial analysts, investors, creditors, competitors, and researchers; internal users include company owners
and management teams. All users of financial ratios conduct financial ratio analysis to track company
performance over time (i.e., trend analysis) and to compare company performance to similar companies or
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the industry average (i.e., peer analysis).

Although there are numerous financial ratios, a select few are usually focused on. Financial ratios are often
organized into five categories, as described below (see also Exhibit 1). Similar to medical test results, these
categories reflect different aspects of a company’s “health.” Exhibit 1 lists all the important and commonly
used ratios under each category, what they measure and how to calculate them.

• Liquidity ratios measure a company’s ability to meet short-term debt obligations. Here, liquidity refers
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to the amount of cash that a firm holds and how quickly a firm can turn its assets into cash.
• Leverage ratios evaluate a company’s capital structure by measuring how a firm uses debt and equity
to finance its operations.
• Efficiency ratios measure how efficiently a company is utilizing its assets and resources.
• Profitability ratios measure a company’s ability to generate profit from its resources.
• Market ratios (also called valuation ratios) evaluate the share price of a company’s stock and imply
whether the stock is underpriced, overpriced, or fairly priced.
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EXHIBIT 1: FINANCIAL RATIOS

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Category How to calculate What it measures
Current assets
Current ratioa = Current liabilities A company’s ability to cover its short-
term debt with its current assets
Liquidity Current assets − Inventories Ability to cover short-term debt with
Acid-test ratiob = Current liabilities
current assets excluding inventories

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Cash and cash equivalents Ability to cover short-term debt with cash
Cash ratio =
Current liabilities and marketable securities
Operating cash flow Ability to cover short-term debt with cash
Operating cash flow ratio =
Current liabilities generated from operating activities

Debt ratio =
Total liabilities The proportion of a company’s assets
Total assets that are financed by debt
Leverage Total liabilities The relative proportion of debt and equity
Debt to equity ratio =

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Shareholders’ equity used to finance a company’s assets
EBIT Ability to cover interest payments with
Interest coverage ratioc = Interest expenses
EBIT
Net sales How efficiently a company is using
Asset turnover ratio = Average total assets
assets to generate sales
Efficiency Cost of goods sold How fast a company sells inventory
Inventory turnover ratio = Average inventory
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Net credit sales How fast a company collects accounts
Receivables turnover ratio = Average accounts receivable
receivable
365 days The average number of days that a
Days sales in inventory ratio = Inventory turnover ratio
company holds its inventory before
selling it
Gross profit % of profit that a company generates
Gross margin ratio = Net sales from sales, after paying cost of goods
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sold
Profitability Net income % of net income that a company
Net profit margin ratio = Net sales
generates from sales
Net income % of profit that a company generates
Return on assets ratio =
Total assets
from its assets
Net income % of profit that a company generates
Return on equity ratio = Shareholders’ equity
from its shareholders’ equity
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Net income The net income a company makes for

Earnings per share =
Total shares outstanding
each share of its stock
Market Dividend per share Total dividends paid % of net income that is paid out to
Dividend payout ratio = Earnings per share
= Net income shareholders in dividends
Dividend per share Total dividends paid How much a company pays out in
Dividend yield ratio = Share price
=Market capitalization
dividends relative to its share price
Share price How much an investor is willing to pay
Price to earnings ratio = Earnings per share
for one dollar of earnings
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Note: EBIT = earnings before interest and taxes.

a
Should be greater than 1 to ensure that current assets can fully cover current liabilities.
b
Should be greater than 1 for firms whose inventories are not so “liquid.”
c
Should be greater than 1 to ensure that operating income or EBIT can fully cover debt interest expenses.
Source: Created by authors.

This document is authorized for educator review use only by Taral Pathak, MICA until May 2023. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or
617.783.7860