Financial statements become truly useful when their numbers are compared and interpreted through ratios. Liquidity ratios measure a company's ability to meet short-term obligations. The current ratio, calculated as Current Assets / Current Liabilities, indicates general short-term solvency, with values above 2:1 often considered healthy. The quick ratio excludes inventory and prepaid expenses, focusing on cash, marketable securities, and receivables divided by current liabilities; a value above 1.0 is generally sound. The cash ratio is the most conservative, dividing cash and cash equivalents by current liabilities. The operating cash flow ratio goes one step further, dividing cash flow from operations by current liabilities to test the ability to pay short-term obligations from actual cash generated.
Solvency and leverage ratios assess longer-term financial structure. The debt-to-equity ratio compares total liabilities to owner's equity, with higher values indicating more leverage and risk. Working capital, defined as Current Assets minus Current Liabilities, offers a simple dollar measure of short-term liquidity. The interest coverage ratio, Operating Income divided by Interest Expense, indicates the ability to service debt, with values below 1.5 signaling potential solvency problems. To gauge efficiency, analysts use the cash conversion cycle, which combines days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO); a shorter cycle frees up working capital and improves liquidity.
Profitability ratios show how well a company converts activity into earnings. Gross profit margin equals gross profit divided by revenue and measures profitability from core operations before overhead. Operating income subtracts selling, general, and administrative expenses from gross profit, while net income is the bottom line after interest and taxes; earnings per share (EPS) divides net income attributable to common shareholders by weighted-average shares outstanding. EBITDA, computed as Operating Income plus Depreciation and Amortization, is often used as a proxy for cash flow, especially for capital-intensive firms. Return on equity (Net Income / Average Equity) measures profitability for owners, return on assets (Net Income / Average Total Assets) measures how efficiently assets produce profit, and the net profit margin expresses net income as a percentage of revenue. The price-to-earnings (P/E) ratio shows how much investors pay for each dollar of current earnings, while book value per share divides total stockholders' equity by shares outstanding. Horizontal analysis compares financial statement line items across multiple periods as percentage changes, and vertical analysis expresses each item as a percentage of a base figure such as revenue or total assets.