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Financial Ratios Glossary

Financial ratios are essential tools for analyzing company performance, valuation, and financial health. This glossary explains the most commonly used ratios in fundamental analysis.

Valuation Ratios

Valuation ratios help investors determine whether a stock is overvalued or undervalued relative to its fundamentals.

Price to Earnings Ratio

P/E Ratio=Price per ShareEarnings per Share\text{P/E Ratio} = \frac{\text{Price per Share}}{\text{Earnings per Share}}

What it measures: The P/E ratio shows how much investors are willing to pay for each dollar of company earnings. It’s one of the most widely used valuation metrics.

How to use it: A higher P/E suggests investors expect higher future growth, while a lower P/E may indicate the stock is undervalued or the company faces challenges. Compare P/E ratios within the same industry, as different sectors have different typical ranges. A P/E of 15-25 is often considered average for mature companies, but growth companies may have much higher ratios.

Price to Free Cash Flow Ratio

P/FCF Ratio=Market CapitalizationFree Cash Flow\text{P/FCF Ratio} = \frac{\text{Market Capitalization}}{\text{Free Cash Flow}}

What it measures: This ratio indicates how much investors pay for each dollar of free cash flow the company generates. Free cash flow is the cash available after capital expenditures.

How to use it: P/FCF is often considered more reliable than P/E because cash flow is harder to manipulate than earnings. A lower P/FCF ratio may indicate better value. Companies with consistent positive free cash flow and low P/FCF ratios are often considered attractive investments. Negative free cash flow makes this ratio less meaningful.

Price to Sales Ratio

P/S Ratio=Market CapitalizationTotal Revenue\text{P/S Ratio} = \frac{\text{Market Capitalization}}{\text{Total Revenue}}

What it measures: The P/S ratio shows how much investors pay for each dollar of company revenue, regardless of profitability.

How to use it: This ratio is particularly useful for evaluating unprofitable companies or those in growth phases. A lower P/S ratio may indicate better value, but it doesn’t account for profitability. Compare P/S ratios within the same industry. High-growth tech companies often have higher P/S ratios than traditional businesses.

Enterprise Value to EBITDA

EV/EBITDA=Enterprise ValueEBITDA\text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}}

Where:

Enterprise Value=Market Cap+Total Debt−Cash\text{Enterprise Value} = \text{Market Cap} + \text{Total Debt} - \text{Cash}

What it measures: This ratio compares a company’s total value (including debt) to its earnings before interest, taxes, depreciation, and amortization. It’s considered a more complete valuation metric than P/E.

How to use it: EV/EBITDA is useful for comparing companies with different capital structures and tax situations. A ratio of 10-14 is often considered reasonable for established companies, but this varies by industry. Lower values may indicate undervaluation, while very high values suggest growth expectations or potential overvaluation. This ratio is especially useful when comparing companies in the same industry with different debt levels.

Profitability Ratios

Profitability ratios measure how efficiently a company generates profit from its operations.

Net Profit Margin

Net Profit Margin=Net IncomeRevenue×100\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times 100

What it measures: The percentage of revenue that remains as profit after all expenses, including taxes and interest.

How to use it: Higher margins indicate better profitability and pricing power. Compare margins across companies in the same industry. A 10% net margin is considered good for most industries, but this varies significantly. Tech and software companies often have higher margins (20-30%), while retail may have lower margins (2-5%). Improving margins over time suggest operational efficiency gains.

Return on Assets

ROA=Net IncomeTotal Assets×100\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} \times 100

What it measures: How efficiently a company uses its assets to generate profit.

How to use it: Higher ROA indicates better asset utilization. A ROA above 5% is generally considered good, but this varies by industry. Capital-intensive industries like manufacturing typically have lower ROA than asset-light businesses like software. Compare ROA to industry peers and look for consistent or improving trends over time.

Return on Equity

ROE=Net IncomeShareholders’ Equity×100\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}} \times 100

What it measures: The return generated on shareholder investments. It shows how much profit a company generates with the money shareholders have invested.

How to use it: A ROE of 15-20% is often considered excellent, indicating the company efficiently uses shareholder capital. However, high ROE can also result from high debt levels (leverage), so always examine it alongside debt ratios. Consistent ROE above the industry average suggests a competitive advantage. Compare ROE trends over time and against competitors.

Return on Invested Capital

ROIC=NOPATInvested Capital×100\text{ROIC} = \frac{\text{NOPAT}}{\text{Invested Capital}} \times 100

Where:

Invested Capital=Total Debt+Equity−Cash\text{Invested Capital} = \text{Total Debt} + \text{Equity} - \text{Cash}

What it measures: How well a company generates returns from all capital invested in the business, including both debt and equity.

How to use it: ROIC is one of the best measures of management effectiveness and competitive advantage. A ROIC above the company’s cost of capital indicates value creation. Companies with ROIC consistently above 15-20% often have strong competitive moats. Compare ROIC to the weighted average cost of capital (WACC) - if ROIC > WACC, the company is creating value.

Cash Flow Ratios

Cash flow ratios analyze a company’s ability to generate cash from operations and convert that into value for shareholders.

Operating Cash Flow to Sales Ratio

OCF/Sales=Operating Cash FlowRevenue×100\text{OCF/Sales} = \frac{\text{Operating Cash Flow}}{\text{Revenue}} \times 100

What it measures: The percentage of sales that is converted into actual cash from operations.

How to use it: Higher ratios indicate better cash conversion from sales. A ratio above 10% is generally positive. Companies with high ratios have strong cash-generating capabilities and less reliance on external financing. Compare this ratio to net profit margin - if operating cash flow is consistently higher than net income, it’s a positive sign of earnings quality.

Free Cash Flow to Operating Cash Flow Ratio

FCF/OCF=Free Cash FlowOperating Cash Flow×100\text{FCF/OCF} = \frac{\text{Free Cash Flow}}{\text{Operating Cash Flow}} \times 100

Where:

Free Cash Flow=Operating Cash Flow−Capital Expenditures\text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capital Expenditures}

What it measures: What percentage of operating cash flow remains after investing in the business (capital expenditures).

How to use it: A higher ratio indicates the company retains more cash after maintaining and growing its asset base. Ratios above 70-80% are excellent and suggest capital-light business models. Lower ratios may indicate heavy reinvestment needs. Growth companies often have lower ratios as they invest heavily in expansion. Compare trends over time - improving ratios suggest maturing business models requiring less reinvestment.

Free Cash Flow Yield

FCF Yield=Free Cash Flow per SharePrice per Share×100\text{FCF Yield} = \frac{\text{Free Cash Flow per Share}}{\text{Price per Share}} \times 100

What it measures: The return an investor would receive from the company’s free cash flow if they bought the stock at the current price.

How to use it: Similar to a dividend yield but based on total free cash flow rather than just dividends. A higher yield may indicate better value. Yields above 5-7% are often considered attractive. This metric helps identify companies generating strong cash returns relative to their stock price. Compare to bond yields and the company’s historical averages.

Free Cash Flow per Share

FCF per Share=Free Cash FlowTotal Shares Outstanding\text{FCF per Share} = \frac{\text{Free Cash Flow}}{\text{Total Shares Outstanding}}

What it measures: The amount of free cash flow generated for each outstanding share of stock.

How to use it: Track this metric over time to see if the company is generating increasing cash per share. Growing FCF per share indicates improving cash generation and potential for dividends or buybacks. Companies that consistently grow FCF per share often make excellent long-term investments. Compare to earnings per share - if FCF per share is lower, the company may have high capital requirements or working capital needs.

Dividend Ratios

Dividend ratios help investors assess a company’s dividend policy and sustainability.

Dividend per Share

DPS=Total Dividends PaidTotal Shares Outstanding\text{DPS} = \frac{\text{Total Dividends Paid}}{\text{Total Shares Outstanding}}

What it measures: The actual dollar amount of dividends paid to shareholders for each share owned.

How to use it: Track dividend per share over time to identify companies with consistent or growing dividends. Companies that regularly increase dividends demonstrate financial strength and shareholder-friendly management. A stable or growing dividend per share is often a sign of predictable cash flows and business stability. Compare to earnings per share and free cash flow per share to assess sustainability.

Dividend Yield

Dividend Yield=Annual Dividend per SharePrice per Share×100\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Price per Share}} \times 100

What it measures: The annual dividend return as a percentage of the current stock price.

How to use it: Dividend yield helps compare income potential across different stocks. Yields of 2-4% are typical for stable companies, while 4-6%+ may indicate higher-yielding sectors like utilities or REITs. Very high yields (8%+) may signal dividend sustainability concerns or declining stock prices. Combine yield analysis with payout ratio to assess safety. A rising yield due to falling stock price is different from a yield increase from dividend growth.

Dividend Payout Ratio

Payout Ratio=Dividends per ShareEarnings per Share×100\text{Payout Ratio} = \frac{\text{Dividends per Share}}{\text{Earnings per Share}} \times 100

What it measures: The percentage of earnings paid out as dividends to shareholders.

How to use it: This ratio indicates dividend sustainability. Payout ratios of 30-50% are often considered healthy, leaving room for dividend growth and business reinvestment. Ratios above 80% may be unsustainable unless the company has very stable earnings. Growth companies often have low payout ratios (or zero) as they reinvest profits. Mature companies typically have higher, more stable payout ratios. Always compare to the industry average and company history.

Using Ratios Together

Financial ratios are most powerful when used in combination rather than isolation:

  • Valuation + Profitability: A low P/E with high ROE may indicate an undervalued quality company
  • Cash Flow + Dividends: Strong free cash flow with moderate payout ratios suggest dividend safety
  • Profitability + Returns: High margins combined with high ROIC indicate competitive advantages
  • Trends Matter: Compare ratios over time (3-5 years) to identify improving or deteriorating fundamentals

Always consider ratios within industry context and alongside qualitative factors like competitive position, management quality, and market trends.