Learn the core profitability, liquidity, leverage, and per-share ratios that investors use after reading the financial statements themselves.
Ratios are shortcuts, not substitutes. A ratio can summarize a relationship quickly, but it only helps if you already understand the underlying statements. That is why strong analysis usually works in this order: read the income statement, balance sheet, and cash flow statement first, then use ratios to compare periods or peer companies.
Most introductory analysis ratios fall into four groups:
flowchart TD
A["Financial ratios"] --> B["Profitability"]
A --> C["Liquidity"]
A --> D["Leverage and coverage"]
A --> E["Per-share metrics"]
Some of the most common introductory formulas are:
[ \text{Gross Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} ]
[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} ]
[ \text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders’ Equity}} ]
[ \text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Shares Outstanding}} ]
These formulas are useful because they compress information, but the interpretation matters more than memorizing symbols.
Profitability ratios ask whether the company is turning revenue or invested capital into acceptable earnings.
Common examples:
Higher is not automatically better in isolation. A margin may look strong because a company sold assets, cut necessary spending, or benefited from a temporary cycle. A comparison becomes more meaningful when you evaluate the same company over time or compare it with similar firms in the same industry.
Liquidity ratios focus on short-term obligations. The current ratio and quick ratio are the most common introductory examples.
These measures can be useful, but the composition of current assets matters:
That is why a headline current ratio should never be accepted blindly.
Leverage ratios help test how much debt risk is embedded in the capital structure. Debt-to-equity is a common first measure. Interest coverage goes further by asking whether earnings are sufficient to cover interest expense.
A company may report solid sales and even decent net income, but if leverage is high and interest coverage is narrowing, the financial risk profile may still be deteriorating.
EPS is especially important because it links profits to common shareholders. Investor.gov defines EPS as a public company’s net profit divided by the number of its common shares. That is why share count matters. If a company issues more shares, total earnings can rise while per-share earnings improve much less.
Exams at this level usually use EPS as a basic profitability measure, not as a cue for advanced valuation models.
A good rule is to compare a ratio:
For example, a debt-to-equity ratio that looks high in one sector may be ordinary in another. A current ratio that looks conservative for a software firm may not mean the same thing for a retailer with large seasonal inventory needs.
Company A and Company B each report a current ratio of 2.0. Company A holds most current assets in cash and Treasury bills. Company B holds most current assets in slow-moving inventory. Both have similar current liabilities. Which statement is most reasonable?
A. Both companies have identical practical liquidity because the current ratio matches B. Company B is clearly safer because inventory is always as liquid as cash C. Company A likely has stronger near-term liquidity despite the same current ratio D. Liquidity cannot be compared once companies share the same ratio
Correct Answer: C
Explanation: Ratios are only a starting point. Asset quality matters. Cash and Treasury bills usually provide stronger immediate liquidity than slow-moving inventory.