Financial Ratios Every Investor Should Know

Valuation Ratios

Valuation ratios help investors determine if a stock is cheap or expensive compared to its underlying fundamentals.

1. Price-to-Earnings (P/E) Ratio

• Formula: Share Price / Earnings Per Share (EPS)
• What Good Looks Like: Generally below 15 for value stocks; higher for fast-growing companies.
• Industry Variations: Tech companies often have P/E ratios above 30, while banks might sit below 10.
• Red Flags: A negative P/E (company is losing money) or an extremely high P/E with no growth to back it up.
• Real Example: Apple (AAPL) historically trades at a P/E of 25-30.

2. Price-to-Book (P/B) Ratio

• Formula: Share Price / Book Value Per Share
• What Good Looks Like: A P/B under 1.0 suggests the stock is trading below its liquidation value.
• Industry Variations: Highly relevant for banks and financial institutions; less relevant for asset-light software companies.
• Red Flags: A P/B ratio above 5 or 10 for companies with significant physical assets.
• Real Example: Bank of America (BAC) often trades around a P/B of 1.0.

3. Price-to-Sales (P/S) Ratio

• Formula: Market Capitalization / Total Revenue
• What Good Looks Like: Typically below 2.0, indicating you are paying less for each dollar of sales.
• Industry Variations: High-margin software companies can command P/S ratios over 10; grocery stores operate on thin margins and have P/S ratios under 0.5.
• Red Flags: Extremely high P/S ratios (e.g., >20) combined with slowing revenue growth.
• Real Example: Microsoft (MSFT) often trades at a P/S above 10 due to high profit margins.

4. Price/Earnings-to-Growth (PEG) Ratio

• Formula: P/E Ratio / Expected Earnings Growth Rate
• What Good Looks Like: A PEG ratio of 1.0 indicates a fairly valued stock. Below 1.0 suggests undervaluation relative to growth.
• Industry Variations: Growth-heavy sectors like biotech may tolerate PEG ratios around 1.5-2.0.
• Red Flags: A PEG over 2.0 suggests the stock's price has outpaced its actual growth trajectory.
• Real Example: Nvidia (NVDA) might have a high P/E but a low PEG due to explosive earnings growth.

5. Enterprise Value to EBITDA (EV/EBITDA)

• Formula: Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization
• What Good Looks Like: Generally, an EV/EBITDA below 10 is considered healthy or undervalued.
• Industry Variations: Capital-intensive industries (telecom, manufacturing) use this heavily because it factors in debt and ignores non-cash depreciation.
• Red Flags: An EV/EBITDA above 15 for a mature, slow-growing business.
• Real Example: AT&T (T) historically trades at a low EV/EBITDA due to massive debt and depreciation.

Profitability Ratios

Profitability ratios measure a company's ability to generate earnings relative to its revenue, operating costs, and balance sheet assets.

6. Return on Equity (ROE)

• Formula: Net Income / Shareholder's Equity
• What Good Looks Like: An ROE of 15-20% is generally considered excellent.
• Industry Variations: Asset-light companies (software) typically have much higher ROE than asset-heavy ones (utilities).
• Red Flags: Consistently declining ROE or a suddenly high ROE driven entirely by massive new debt rather than profit.
• Real Example: Home Depot (HD) is known for extremely high ROE numbers.

7. Return on Assets (ROA)

• Formula: Net Income / Total Assets
• What Good Looks Like: An ROA over 5% is solid; over 10% is excellent.
• Industry Variations: Banks have very low ROA (often ~1%) because their assets (loans) are massive compared to income.
• Red Flags: ROA falling year-over-year while asset base grows, indicating inefficient capital deployment.
• Real Example: Alphabet (GOOGL) maintains a strong ROA due to massive cash flow and relatively few hard assets.

8. Return on Investment (ROI)

• Formula: (Net Profit / Cost of Investment) * 100
• What Good Looks Like: Double-digit returns outperforming the broader market average (e.g., >10%).
• Industry Variations: Highly variable; tech startups aim for massive ROI, while utilities target slow, steady returns.
• Red Flags: Negative ROI or ROI consistently below the cost of capital.
• Real Example: Amazon (AMZN) investing heavily in AWS yielded massive historical ROI.

9. Net Profit Margin

• Formula: (Net Income / Total Revenue) * 100
• What Good Looks Like: Generally above 10%; exceptional above 20%.
• Industry Variations: Supermarkets have margins of 1-3%; luxury goods or software can exceed 25%.
• Red Flags: Shrinking margins despite rising revenue (indicating rising costs).
• Real Example: Walmart (WMT) operates on low net margins (~2-3%) but massive volume.

10. Gross Margin

• Formula: ((Revenue - Cost of Goods Sold) / Revenue) * 100
• What Good Looks Like: Generally above 40%; indicates strong pricing power.
• Industry Variations: Software companies often have gross margins over 80%; automakers around 15-20%.
• Red Flags: Gross margin compression over multiple quarters, suggesting lost pricing power or rising raw material costs.
• Real Example: Adobe (ADBE) maintains gross margins near 85%.

Liquidity Ratios

Liquidity ratios assess a company's ability to pay off its short-term debts and obligations.

11. Current Ratio

• Formula: Current Assets / Current Liabilities
• What Good Looks Like: A ratio between 1.5 and 2.0 indicates strong short-term financial health.
• Industry Variations: Retailers might operate slightly below 1.0 due to high inventory turnover.
• Red Flags: A ratio below 1.0 (cannot pay short-term debts) or over 3.0 (hoarding cash inefficiently).
• Real Example: Johnson & Johnson (JNJ) maintains a very healthy current ratio.

12. Quick Ratio (Acid-Test)

• Formula: (Current Assets - Inventory) / Current Liabilities
• What Good Looks Like: A ratio of 1.0 or higher is considered safe.
• Industry Variations: Crucial for retail or manufacturing where inventory cannot be instantly liquidated.
• Red Flags: A quick ratio significantly lower than the current ratio implies dangerous reliance on selling inventory to survive.
• Real Example: Target (TGT) relies heavily on inventory, so its quick ratio is much lower than its current ratio.

13. Cash Ratio

• Formula: Cash and Cash Equivalents / Current Liabilities
• What Good Looks Like: A ratio above 0.5 indicates very strong immediate liquidity.
• Industry Variations: Tech companies often stockpile cash, resulting in high cash ratios.
• Red Flags: Near-zero cash ratios in volatile industries.
• Real Example: Meta (META) frequently holds massive cash reserves, driving up its cash ratio.

Leverage Ratios

Leverage (or solvency) ratios measure how much debt a company is using to finance its assets and operations.

14. Debt-to-Equity (D/E) Ratio

• Formula: Total Liabilities / Shareholder's Equity
• What Good Looks Like: A D/E ratio below 1.0 is generally considered safe.
• Industry Variations: Utilities and real estate investment trusts (REITs) often safely operate with D/E ratios of 2.0 or higher.
• Red Flags: A D/E ratio above 2.0 in cyclical industries like consumer discretionary.
• Real Example: Ford (F) carries substantial debt, leading to a high D/E ratio compared to tech peers.

15. Interest Coverage Ratio

• Formula: Operating Income (EBIT) / Interest Expense
• What Good Looks Like: A ratio of 3.0 or higher suggests the company can comfortably pay interest on its debt.
• Industry Variations: Stable utility companies can afford lower coverage ratios than volatile commodity businesses.
• Red Flags: A ratio below 1.5 indicates a high risk of default if revenues dip slightly.
• Real Example: ExxonMobil (XOM) monitors this closely due to the cyclical nature of oil prices.

Efficiency Ratios

Efficiency ratios show how well a company utilizes its assets and manages its liabilities internally.

16. Asset Turnover Ratio

• Formula: Net Sales / Average Total Assets
• What Good Looks Like: Higher is better; indicates generating more sales per dollar of assets.
• Industry Variations: Discount retailers have very high asset turnover; real estate holding companies have very low turnover.
• Red Flags: A declining ratio over several years suggests the company is expanding assets without a corresponding boost in sales.
• Real Example: Costco (COST) achieves massive sales volume relative to its physical store assets.

17. Inventory Turnover Ratio

• Formula: Cost of Goods Sold / Average Inventory
• What Good Looks Like: A higher ratio indicates strong sales and efficient inventory management (e.g., 5 to 10).
• Industry Variations: Grocery stores turn inventory constantly (high ratio); heavy machinery manufacturers turn it slowly (low ratio).
• Red Flags: A sudden drop implies unsold goods are piling up on shelves (dead stock).
• Real Example: Zara (Inditex) revolutionized fast fashion with incredibly high inventory turnover.

18. Days Sales Outstanding (DSO)

• Formula: (Accounts Receivable / Total Credit Sales) * Number of Days
• What Good Looks Like: A lower number (e.g., under 45 days) means the company collects cash from customers quickly.
• Industry Variations: B2B companies often have longer DSOs (net-60 or net-90 terms) compared to B2C retail.
• Red Flags: DSO creeping up over time suggests customers are struggling to pay or collection efforts are failing.
• Real Example: Salesforce (CRM) closely tracks DSO for its enterprise software subscriptions.

19. Accounts Payable Turnover

• Formula: Total Supplier Purchases / Average Accounts Payable
• What Good Looks Like: A balanced ratio; too high means paying suppliers instantly (losing cash flow leverage), too low risks supplier relationships.
• Industry Variations: Large retailers force long payment terms on suppliers, leading to a lower turnover ratio but better cash flow for the retailer.
• Red Flags: A sudden, massive drop might indicate the company is physically unable to pay its suppliers.
• Real Example: Amazon (AMZN) famously stretches its accounts payable to fund its own operations.

20. Return on Capital Employed (ROCE)

• Formula: EBIT / Capital Employed (Total Assets - Current Liabilities)
• What Good Looks Like: A ROCE consistently above the company's cost of capital (typically > 15%).
• Industry Variations: Preferred over ROE in capital-intensive sectors like oil, gas, and telecommunications because it factors in debt capital.
• Red Flags: ROCE dropping below the interest rate paid on debt destroys shareholder value.
• Real Example: BP (BP) uses ROCE as a primary metric for assessing major drilling project viability.