Financial Ratios

Financial ratios compress a company's financial statements into comparable, interpretable numbers. They answer questions like: How profitable is this business? How leveraged? How efficiently does it use capital? Ratios let you compare companies of different sizes, across time, and against benchmarks. A single number — return on equity, debt-to-EBITDA, current ratio — can summarise a dimension of performance or risk.

The main categories are profitability (margins, ROE, ROIC), liquidity (current ratio, quick ratio), leverage (debt/equity, interest coverage), and efficiency (asset turnover, inventory days). Each ratio is a fraction: one line item divided by another. The numerator and denominator must be chosen so the ratio is meaningful. Revenue margin is profit over revenue; ROE is net income over equity. The same inputs can be combined in different ways for different questions. The discipline is to know what each ratio measures and what it doesn't — and to use several ratios together rather than one in isolation.

Ratios are not truth; they are summary statistics. They can be gamed (window-dressing balance sheets, shifting revenue recognition), and they reflect accounting choices (GAAP vs non-GAAP, depreciation, leases). They also lag: they describe the past. For forecasting and valuation, ratios are inputs — they help you understand the business and build assumptions — but the output (value) comes from cash flow and discounting. Use ratios to screen, compare, and diagnose; don't confuse a good ratio with a good investment.