7 IMPORTANT FINANCIAL RATIOS

1. Quick ratio
We’ll start off our list of the most important financial ratios with
the quick ratio, also known as the acid test. This is one of the most
frequently used types of financial ratios, giving a quick indicator of
business liquidity. To calculate the quick ratio, you must subtract
current inventory from current assets and then divide this by
liabilities:

(Current Assets – Inventory) / Current Liabilities

This shows you how easily a business’s short-term debts will be

covered by its existing liquid assets, or cash. If the quick ratio is
greater than one, the business is in a good financial position.

2. Working capital ratio

The second ratio pertaining to liabilities is the working capital
ratio, also known as the current ratio. Like the quick ratio, this
looks at how well a company can pay its existing debts. However, it
considers all current assets rather than simply liquid assets, so you
don’t need to subtract inventory from the equation. The working
capital ratio looks like this when written as a formula:

Current Assets / Current Liabilities

The higher the working capital ratio, the easier it will be for a
business to pay off debts using its current assets.

3. Debt to equity ratio

Another financial ratio to consider is debt to equity. This looks at
whether or not a business is borrowing more than it can reasonably
pay back using equity as a metric. To calculate debt to equity, you
must divide total liabilities by shareholders equity:

Total Liabilities / Shareholders Equity

In other words, this ratio measures the degree to which the

business’s operations are funded by debt. When this ratio is greater
than one, the company holds more debt. If the value is below one,
it indicates that the company holds less debt.

4. Price to earnings ratio

We’ve looked at a few of the key financial ratios related to
liabilities, but what about those related to earnings? One of the top
indicators for earnings potential is the price to earnings ratio, or
P/E. This divides a company’s share price by its earnings per share.

Share Price / Earnings per Share

In other words, it measures the amount an investor would pay for

each dollar earned. This gives you a quick idea if a stock is under or
overvalued. Because share prices vary by industry and market
conditions, there isn’t a universal rule for what constitutes a
“good” P/E. However, you can compare the company’s P/E to
similar stock prices for comparison.

5. Earnings per share

Along these same lines is the earnings per share or EPS, another
quick ratio to use when assessing future earnings. Earnings per
share measures the net income you’ll receive for each share of a
company’s stock. To calculate EPS, you must divide net income by
the number of outstanding common shares during the financial
year.

Net Income / Outstanding Shares

This can potentially be a negative number, if the company has

traded at a loss over the year. Usually, investors will look at EPS in
combination with a number of other ratios like P/E to determine
growth potential.

6. Return on equity ratio

Whether you’re investing your own money or interested in keeping
shareholders happy, you’ll need to know the return on equity ratio.
This is one of the most important financial ratios for calculating
profit, looking at a company’s net earnings minus dividends and
dividing this figure by shareholders equity.
(Earnings – Dividends) / Shareholders Equity

The result tells you about a company’s overall profitability, and can
also be referred to as return on net worth.

7. Profit margin
Speaking of profitability, the profit margin is one of the
fundamental financial ratios to be aware of. This shows you how
efficiently a company is managing its overall costs, or how well it
converts revenue into profit. The formula for profit margin is:

Profit / Revenue

You can then multiply the result by 100 to convert it into a

percentage. The higher the profit margin, the more efficient the
company is in converting sales to profits.