Finance Ratio Cheat Sheet: Understanding Business Health

Financial ratios are powerful tools used to analyze a company's performance and financial health. They provide insights into profitability, liquidity, solvency, and efficiency. This cheat sheet provides a quick reference for key ratios, their formulas, and interpretations.

I. Profitability Ratios: Measuring Earnings Performance

Profitability ratios assess a company's ability to generate profits relative to revenue, assets, or equity.

• Gross Profit Margin: (Gross Profit / Revenue) x 100. Indicates the percentage of revenue remaining after deducting the cost of goods sold. A higher margin suggests better control over production costs.
• Operating Profit Margin: (Operating Income / Revenue) x 100. Shows the profitability of core operations before interest and taxes. Indicates how efficiently the company manages its business.
• Net Profit Margin: (Net Income / Revenue) x 100. Represents the percentage of revenue remaining after all expenses, including taxes and interest, are paid. The higher the better.
• Return on Assets (ROA): (Net Income / Total Assets) x 100. Measures how efficiently a company uses its assets to generate profit. A higher ROA is generally desirable.
• Return on Equity (ROE): (Net Income / Shareholders' Equity) x 100. Indicates the return generated for each dollar of shareholder investment. A higher ROE generally means the company is more efficient at using equity financing.

II. Liquidity Ratios: Assessing Short-Term Obligations

Liquidity ratios measure a company's ability to meet its short-term financial obligations.

• Current Ratio: Current Assets / Current Liabilities. Indicates the company's ability to pay off its current liabilities with its current assets. A ratio above 1 generally indicates sufficient liquidity. A ratio of 2 is often considered ideal.
• Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities. A more stringent measure than the current ratio, as it excludes inventory, which may not be easily converted to cash. A quick ratio above 1 is considered healthy.
• Cash Ratio: (Cash + Cash Equivalents) / Current Liabilities. The most conservative liquidity ratio, assessing the ability to pay off short-term liabilities using only cash and equivalents.

III. Solvency Ratios: Evaluating Long-Term Financial Health

Solvency ratios assess a company's ability to meet its long-term financial obligations.

• Debt-to-Equity Ratio: Total Debt / Shareholders' Equity. Indicates the proportion of debt financing relative to equity financing. A lower ratio suggests lower financial risk.
• Debt-to-Assets Ratio: Total Debt / Total Assets. Measures the proportion of a company's assets that are financed by debt. A higher ratio indicates higher leverage.
• Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense. Indicates a company's ability to cover its interest expense with its operating income. A higher ratio indicates a greater ability to service debt.

IV. Efficiency Ratios: Measuring Operational Effectiveness

Efficiency ratios measure how effectively a company utilizes its assets and manages its liabilities.

• Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory. Measures how quickly a company sells its inventory. A higher turnover rate indicates efficient inventory management.
• Accounts Receivable Turnover Ratio: Revenue / Average Accounts Receivable. Measures how quickly a company collects its receivables. A higher turnover rate indicates efficient credit and collection policies.
• Accounts Payable Turnover Ratio: Cost of Goods Sold / Average Accounts Payable. Measures how quickly a company pays its suppliers.
• Asset Turnover Ratio: Revenue / Total Assets. Measures how efficiently a company uses its assets to generate revenue. A higher ratio indicates better asset utilization.

Important Note: Ratio analysis is most effective when comparing a company's ratios to industry averages or to its own historical performance. Ratios should be interpreted in context and not in isolation. Industry benchmarks and trends can drastically change the interpretation of any individual ratio.