What is the key ratio analysis? Key ratio analysis is one of the most essential tools used in fundamental analysis to understand a company's financial health and stock valuation. Investors, analysts, and portfolio managers use key ratios to extract insights from a company's financial statements and make informed investment decisions. These ratios provide a numeric snapshot of a company’s operations, profitability, efficiency, liquidity, and risk exposure.

In this guide, we’ll explore the key ratios for stock analysis, explain how they are calculated, and how you can use them to compare companies and make informed investing decisions.

Purpose of Key Ratios in Stock Analysis

Key ratios serve two primary functions:

• Stock Valuation: They help investors assess whether a stock is fairly valued, overvalued, or undervalued.
• Comparative Analysis: They enable easy comparison of a company’s financial position against its industry peers.

Because of their focus on assessing value, these ratios are also known as valuation ratios. Let's now break down the most important types of key ratios used in stock analysis.

1. Valuation Ratios

These ratios help determine a company's market value relative to its earnings or book value.

Price-to-Earnings (P/E) Ratio

The P/E ratio compares a company’s stock price to its earnings per share (EPS):

P/E Ratio = Market Price per Share / Earnings per Share (EPS)

• EPS = Net Income / Number of Outstanding Shares
• A high P/E may indicate overvaluation or high future growth expectations.
• A low P/E might suggest undervaluation or weak growth prospects.

Price-to-Book Value (P/B) Ratio

This ratio uses the balance sheet to compare the market price to the book value per share:

P/B Ratio = Market Price per Share / Book Value per Share

• Book Value includes share capital, retained earnings, reserves, and other components of equity.
• A P/B ratio < 1 often implies undervaluation, whereas a P/B > 1 could mean overvaluation depending on industry standards.

2. Profitability Ratios

Profitability ratios evaluate how efficiently a company generates profit relative to revenue, assets, or equity. These ratios answer the question: Is the company making money?

• Gross Profit Margin = Gross Profit / Revenue
• Operating Profit Margin = Operating Profit / Revenue
• Net Profit Margin = Net Profit / Revenue
• Return on Equity (ROE) = Net Profit / Average Equity

3. Liquidity Ratios

What are the 5 ratios in ratio analysis? Among the core five, liquidity ratios are key to measuring a firm’s ability to meet short-term liabilities using its current assets. These ratios highlight working capital management.

Important Liquidity Ratios:

• Current Ratio = Current Assets / Current Liabilities
  (Ideal value: >1, but not excessively high)
• Quick Ratio = (Cash + Short-Term Investments + Accounts Receivable) / Current Liabilities
  (Also known as Acid-Test Ratio)
• Cash Ratio = (Cash + Short-Term Investments) / Current Liabilities

These ratios are crucial for assessing financial stability during tough economic conditions or seasonal slowdowns.

4. Efficiency Ratios (Activity Ratios)

Efficiency ratios assess how effectively a company uses its assets to generate income. They analyze the cash conversion cycle, which refers to how quickly inventory is sold, revenue is collected, and suppliers are paid.

Key Efficiency Ratios:

• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Receivables Turnover = Revenue / Average Accounts Receivable
• Payables Turnover = (COGS + Opening Inventory – Closing Inventory) / Average Accounts Payable

These can also be measured in days:

• Days Inventory Outstanding (DIO) = 365 / Inventory Turnover
• Days Sales Outstanding (DSO) = 365 / Receivables Turnover
• Days Payable Outstanding (DPO) = 365 / Payables Turnover

Shorter cycles are typically better, indicating faster revenue realization and improved cash flow.

5. Risk (Solvency) Ratios

Risk or solvency ratios help evaluate a company’s financial leverage and its ability to repay long-term obligations. These are particularly important for creditors and shareholders to understand the level of financial risk.

Key Risk Ratios:

• Debt to Total Capital = Total Debt / (Total Debt + Total Equity)
• Debt to Equity (D/E) = Total Debt / Total Equity
  (Higher ratios indicate more debt and therefore higher financial risk)
• Interest Coverage Ratio = EBIT / Interest Expense
  (Higher values show better debt servicing capacity)
• Fixed Cost Coverage Ratio = (EBIT + Lease Payments) / (Interest + Lease Payments)

High leverage can lead to higher returns, but it also increases the risk of insolvency during downturns.

Summary Table: What are the 5 Ratios in Ratio Analysis?

Quick Recap

• What is the key ratio analysis? It is the process of using financial ratios to evaluate a company’s fundamentals.
• These ratios are essential for fundamental analysis and can help determine stock valuation and company performance.
• What are the key ratios for stock analysis? They include P/E, P/B, ROE, Debt to Equity, and Current Ratio, among others.
• What are the 5 ratios in ratio analysis? Valuation, Profitability, Liquidity, Efficiency, and Risk/Solvency Ratios.

By learning and applying these ratios, investors can make more informed, data-driven decisions and identify the most promising opportunities in the stock market.

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