Financial Ratios Mastery

Learn to analyze stocks using key financial metrics

Beginner Friendly
15 min read
What You'll Learn

Key Concepts:

  • • How to calculate and interpret 12+ essential ratios
  • • What constitutes good vs. bad ratio values
  • • Industry-specific considerations
  • • Common pitfalls to avoid

Practical Skills:

  • • Compare companies within the same sector
  • • Identify undervalued investment opportunities
  • • Assess financial health and risk
  • • Make informed investment decisions
Valuation Ratios
Determine if a stock is overvalued or undervalued
Price-to-Earnings (P/E)
Stock Price ÷ Earnings Per Share
Interpretation:

Lower P/E may indicate undervaluation, but consider growth prospects

Good Range:
15-25 for most stocks
Example:

If a stock trades at $50 and EPS is $2.50, P/E = 20

Price-to-Book (P/B)
Stock Price ÷ Book Value Per Share
Interpretation:

P/B < 1 may indicate undervaluation, especially for asset-heavy companies

Good Range:
1-3 for most industries
Example:

Stock at $30 with book value of $20 per share = P/B of 1.5

Price-to-Sales (P/S)
Market Cap ÷ Total Revenue
Interpretation:

Useful for companies with no profits yet, lower is generally better

Good Range:
1-2 for mature companies
Example:

Company with $1B market cap and $500M revenue = P/S of 2

EV/EBITDA
Enterprise Value ÷ EBITDA
Interpretation:

Accounts for debt, good for comparing companies with different capital structures

Good Range:
10-15 for most industries
Example:

EV of $2B and EBITDA of $200M = EV/EBITDA of 10

Profitability Ratios
Measure how efficiently a company generates profits
Return on Equity (ROE)
Net Income ÷ Shareholders' Equity
Interpretation:

Higher ROE indicates efficient use of shareholder money

Good Range:
15-20% is excellent
Example:

Net income of $100M with equity of $500M = ROE of 20%

Return on Assets (ROA)
Net Income ÷ Total Assets
Interpretation:

Shows how efficiently company uses its assets to generate profit

Good Range:
5-10% is good
Example:

Net income of $50M with assets of $1B = ROA of 5%

Gross Margin
(Revenue - COGS) ÷ Revenue
Interpretation:

Higher margins indicate pricing power and efficiency

Good Range:
Varies by industry, 20%+ is generally good
Example:

Revenue of $1M, COGS of $600K = Gross margin of 40%

Operating Margin
Operating Income ÷ Revenue
Interpretation:

Shows profitability after operating expenses

Good Range:
10-15% is solid
Example:

Operating income of $200M on revenue of $1B = 20% margin

Financial Health Ratios
Assess the financial stability and risk of a company
Debt-to-Equity
Total Debt ÷ Total Equity
Interpretation:

Lower ratios indicate less financial risk

Good Range:
Below 0.5 is conservative, below 1.0 is acceptable
Example:

Debt of $300M and equity of $600M = D/E of 0.5

Current Ratio
Current Assets ÷ Current Liabilities
Interpretation:

Measures ability to pay short-term obligations

Good Range:
1.5-3.0 is healthy
Example:

Current assets of $500M and liabilities of $250M = ratio of 2.0

Quick Ratio
(Current Assets - Inventory) ÷ Current Liabilities
Interpretation:

More conservative liquidity measure excluding inventory

Good Range:
1.0 or higher is good
Example:

Quick assets of $300M and current liabilities of $250M = 1.2

Interest Coverage
EBIT ÷ Interest Expense
Interpretation:

Shows ability to pay interest on debt

Good Range:
5x or higher is safe
Example:

EBIT of $100M and interest of $10M = coverage of 10x

Key Takeaways

Best Practices:

  • • Always compare ratios within the same industry
  • • Look at trends over multiple years, not just one quarter
  • • Use multiple ratios together for a complete picture
  • • Consider the company's growth stage and business model

Red Flags to Watch:

  • • Declining ROE over multiple years
  • • Very high debt-to-equity ratios
  • • Current ratio below 1.0
  • • Extremely high P/E without justification

Ready for the Next Level?

Now that you understand financial ratios, learn how to combine them with technical analysis for more comprehensive investment decisions.