Financial ratios turn a pile of statement numbers into a handful of comparable figures. Used well, they tell you in minutes what a company's financials are saying. Used carelessly, they mislead. This is Part 6 of our Read the Numbers series. It collects ten ratios in one place, with the formula, a worked example from the same hypothetical distributor we've followed since the balance sheet, and the catch to watch for with each.
Formulas for several of these follow FINRA's guide, Financial Performance Metrics Every Investor Should Know. FINRA's consistent advice is to compare a ratio with peers in the same industry rather than judging it in isolation, and that's the one rule worth carrying through the whole list.
The ten ratios
| Ratio and formula | Example | What it tells you | The catch |
|---|---|---|---|
| 1. Gross margin (revenue − cost of goods sold) ÷ revenue | 40.0% | Whether the company sells its product for meaningfully more than it costs. | Normal levels differ enormously by industry. |
| 2. Operating margin EBIT ÷ revenue | 11.7% | Profit from the core operation, before interest and taxes. FINRA notes it's best used to compare peers. | One-time items can distort a single year. |
| 3. Net margin net income ÷ revenue | 8.0% | What's left of each sales dollar after every expense. | Swings in tax rates or interest can move it without any change in the business. |
| 4. Earnings per share (EPS) net income ÷ shares outstanding | $9.60 (assuming 10,000 shares) | Profit per share, which makes companies of different sizes comparable. | Buybacks and new share issuance change it without changing profit. |
| 5. Price-to-earnings (P/E) stock price ÷ EPS | 20.0 (at an assumed $192 share price) | How much investors pay for each dollar of earnings. See Part 7. | A low P/E isn't automatically cheap. |
| 6. Return on equity (ROE) net income ÷ shareholder equity | 38.4% | How much profit the owners' capital generates. | Heavy debt shrinks equity and inflates ROE. |
| 7. Interest coverage EBIT ÷ interest expense | 11.7× | How comfortably operating profit covers interest payments. Lower ratios mean less cushion. | Ignores principal repayments. |
| 8. Current ratio current assets ÷ current liabilities | 2.0 | Whether the company can cover obligations due within a year. | Inventory counts as a current asset but may not convert to cash quickly. |
| 9. Debt-to-equity total liabilities ÷ equity | 1.0 | How much of the company is financed by borrowing versus owners' capital. | Compare within an industry; utilities and software differ widely. |
| 10. Dividend payout ratio dividends ÷ net income | 20.8% ($20,000 ÷ $96,000) | How much of profit is paid out to owners. See Part 9. | Earnings can be temporarily high or low; check cash flow too. |
Every example number ties back to the statements in Part 3: $1,200,000 revenue, $480,000 gross profit, $140,000 operating income, $96,000 net income, $250,000 equity, and $20,000 in owner distributions.
How to use them without fooling yourself
- Compare with peers and with history. A margin or ratio means little alone. FINRA specifically cautions that average ratios vary significantly across industries.
- Read ratios in pairs. ROE looks impressive until you check debt-to-equity. A strong current ratio matters less if interest coverage is thin.
- Check cash, not just profit. Several ratios here start from net income, which includes non-cash items and uncollected sales. Pair them with free cash flow.
- Watch the trend. A ratio moving the wrong way for several periods in a row tells you more than any single reading.
Common questions
Which financial ratios are most important?
It depends on the question. Profitability ratios such as operating margin and return on equity show earning power, the current ratio and interest coverage show short-term safety, and debt-to-equity shows how the company is financed. Together they give a more reliable picture than any one ratio.
What is a good debt-to-equity ratio?
There's no universal number. Capital-intensive industries such as utilities and real estate typically carry more debt than software or services companies, so the most useful comparison is with similar companies in the same industry.
Where do I find the numbers to calculate ratios?
In the company's financial statements, found in its 10-K and 10-Q filings on the SEC's EDGAR database. Many brokerage and data sites also calculate common ratios, but the filing is the primary source.
- How to Read a Balance Sheet in Five Minutes
- How to Read an Income Statement in Five Minutes
- How to Read a Cash Flow Statement: Why Profit Isn't the Same as Cash
- The Three Financial Statements, Explained as One Story
- How to Read a 10-K Without Falling Asleep
- How to Read an Earnings Report: Beat, Miss, Guidance, and Why Good News Can Sink a Stock
- P/E Ratio Explained: What It Tells You and Why a Low One Can Be a Trap
- Free Cash Flow Explained: The Number Patient Investors Watch, and Where It Can Mislead
- Dividend Payout Ratio: How to Tell Whether a Dividend Is Safe
- How to Read a Fund Fact Sheet, and Why the Expense Ratio Comes First