Ratio Analysis is a common practice used by the financial community as a means of measuring the health or performance of a company, and comparing metrics over time or across multiple companies.

Ratio Analysis is a useful method for putting a particular metric in perspective, instead of looking at a actual number itself. It’s difficult to know if annual revenue of $1B for company A is good compared to revenue of $500M for company B, but using a ratio such as Price to Sales, you can see that company A has a ratio of 20x while company B is only 5x. This tells you that even though the revenue is larger at A, company B is actually priced better for the amount of revenue being generated.

Similarly, it’s difficult to gauge a company’s health just by looking at the financial statement values. For example, how do you know if a company carrying $50B of debt is safe or over-leveraged? Comparing that value as a ratio of Free Cash Flow or Revenue gives you a basis of understanding the context of that debt. If a company has a Long Term Debt to Free Cash Flow ratio under 5x, that means it would only take 5 years to be completely debt free using only their free cash, and may justify the $50B on the balance sheet.

Activity Ratios

Inventory Turnover = cost of goods sold / average inventory

Days of Inventory on Hand = 365 / inventory turnover

Total Assets Turnover = revenue / average total assets

Liquidity Ratios

Current Ratio = current assets / current liabilities

Quick Ratio = cash + securities + receivables / current liabilities

Cash Ratio = cash / current liabilities

Solvency Ratios

Debt to Equity = total debt / total equity

Financial Leverage = average total assets / average total equity

Interest Coverage = EBIT / interest expense

Free Cash Debt Coverage = free cash flow / total long term debt

Profitability Ratios

Operating Profit Margin = EBIT / revenue

Net Profit Margin = net income / revenue

Return on Assets = (net income + interest expense(1-tax rate)) / average total assets

Return on Equity = (net income + interest expense(1-tax rate)) / average total equity

Valuation Ratios

Price to Earnings = price / net income

Price to Free Cash Flow = price / free cash flow

Price to Sales = price / sales

The metrics can be used in various ways. Two common practices are to compare different companies against each other, and to compare the same company over time. Comparing different companies allows you to see which one is better, at least according to the numbers on their financial statements. Looking at the ratios of the same company over time allows you to see how the company is changing. Are the ratios improving over time or getting worse? Maybe one part of the business is struggling while other areas are improving?