Company analysis is one of the main three components of fundamental analysis. It is also worth mentioning that an integral part of performing a company analysis is evaluating the financial health of a particular company using financial ratios. This is specifically called financial ratio analysis. The data and information drawn from determining and analyzing financial ratios provide insight into the particular financial position of a company, allow comparison among companies, and enable investors to make more informed investment decisions.

**Essential Financial Ratios for Investors: A Definitive Primer to the Financial Ratio Analysis for Fundamental Analysis**

Several tenured investors, investment analysts, and fund managers who believe in the importance of analyzing and understanding the fundamentals of companies even consider financial ratios as the cornerstone of fundamental analysis. This is because financial ratios provide insights into the financial health, performance, and valuation of a company. These ratios are calculated using data from financial statements like the income statement, balance sheet, and cash flow statement. The corresponding discussions below enumerate and describe the essential financial ratios used in fundamental analysis.

**1. Liquidity Ratios**

The financial metrics used to measure the ability of a company to meet its short-term obligations like accounts payable, short-term debt, and other liabilities needed to be paid within one year are called liquidity ratios. These financial ratios can provide insight into the short-term financial position of a particular company.

High liquidity ratios specifically signal an ability to invest in growth opportunities, roll out dividend payouts or deliver shareholder value, and creditworthiness. Declining financial ratios give investors ample time to react and reconsider their investments because these are early indicators of potential financial problems.

**Below are the key liquidity ratios used in fundamental analysis:**

**• Current Ratio:** Measures the ability of a company to cover its short-term obligations with its short-term assets. This is computed by dividing current assets by current liabilities. A ratio greater than 1 indicates the company can cover its immediate obligations like short-term debts using its current assets. A ratio less than 1 or a low current ratio may indicate potential issues in meeting short-term obligations due to a lack of current assets.

**• Quick Ratio: **Provides a stricter measure of liquidity than the current ratio because it factors out inventory from the current assets. Inventory is factored out because it can take time to sell and is not readily convertible to cash. This is determined by the difference between current assets and inventory, and dividing the difference by current liabilities. A ratio greater than 1 indicates stronger ability to meet immediate obligations.

**• Cash Ratio:** Measures the ability of a company to cover its short-term obligations with its most liquid assets. These assets are cash and cash equivalents. It is computed by adding cash and cash equivalents and dividing the sum by current liabilities. A ratio greater than 1 shows a strong liquid position. A low cash ratio suggests the company may struggle to meet its short-term obligations without selling other assets or securing additional financing.

**2. Solvency Ratios**

Solvency ratios run in stark contrast with liquidity ratios. They are metrics used to assess the ability of a company to meet its long-term financial obligations. These obligations are debts or liabilities that are needed to be repaid over a period longer than one year. Examples include loans or bonds with maturity dates beyond one year.

Investors who hold bonds or are planning to invest in bonds issued by a company reference these financial ratios to assess the likelihood of fulfilling or defaulting debt obligations. These ratios can also help in understanding the capital structure of a company because they provide insight into the balance between debt and equity financing.

**Below are the key solvency ratios used in fundamental analysis:**

**• Debt-to-Equity Ratio:** Measures the relative proportion of equity and debt used to finance the assets of the company. This is computed by dividing total debt by the total equity of shareholders. A higher ratio indicates that a company relies more on debt than equity for financing. This also suggests an increase in the risk of financial distress if the company cannot meet its debt obligations. A balanced ratio suggests a healthy mix and extreme values that are either too low or too high may indicate potential issues.

**• Interest Coverage Ratio:** Measures the ability of a company to cover and meet its interest obligations from its operating earnings. This is computed by dividing earnings before interest or EBIT by interest expense. A higher ratio indicates that the company comfortably generates enough earnings to cover its interest payments, has a lower risk of defaulting, generates profits to meet debts, and has good creditworthiness. A declining interest coverage ratio can be an early warning sign of financial trouble.

**3. Profitability Ratios**

The financial metrics used to evaluate the ability of a company to generate income relative to its revenue, operating costs, balance sheet assets, or equity from shareholders are called profitability ratios. These financial ratios generally provide critical insights into the operational efficiency of a company and its overall financial health.

Profitability ratios are specifically used by investors and investment analysts to determine the capabilities of a company to convert sales into profits or use its assets and equity to generate profits. These ratios can also help in comparing companies within the same industry or provide insights as regards existing competitive challenges.

**Below are the key financial ratios used in fundamental analysis:**

**• Gross Profit Margin:** Measures the profitability of core operations and reflects the efficiency of production and pricing strategies. This is computed by dividing gross profit by revenue. A higher gross profit margin suggests better control over production costs and stronger pricing power. Monitoring changes in the gross profit margin over time also helps in gauging future profitability and potential issues with cost management.

**• Operating Profit Margin: **Measures profitability after deducting operating expenses. It indicates the ability of a company to generate profits from core operations and control its operational costs. This is computed by dividing operating income by revenue and multiplying the result by 100. A high operating profit margin suggests effective control over operating costs and strong operational performance.

**• Net Profit Margin:** Measures the overall profitability of a company after all expenses and including taxes and interests. It indicates the percentage of revenue that translates into net income. This is computed by dividing net income by revenue and multiplying the result by 100. A high net profit margin suggests strong overall financial health and efficient cost management. It also impacts earnings per share and dividend payments.

**• Return on Assets:** Measures how efficiently a company generates profit from its assets. This means that a higher return on assets or ROA indicates a more efficient use of assets. It is computed by dividing net income by total assets and multiplying the results by 100. Investors compare ROA across companies to evaluate relative performance and operational efficiency and help them understand the capital intensity of a business.

**• Return on Equity:** Measures the profitability generated for shareholders relative to their investment to indicate how effectively a company uses equity financing to generate profits. This is computed by dividing net income by the equity of shareholders and multiplying the result by 100. A higher ROE suggests a company is more efficient at generating profits from its equity base. This is seen as a sign of strong management.

**4. Efficiency Ratios**

Efficiency ratios assess the ability of a company to effectively and efficiently utilize its resources, such as assets and liabilities, to generate sales and maximize profit generation. These financial ratios specifically provide insights into how a company operates and manages its operations in consideration of all of its assets and liabilities.

These ratios are critical for fundamental analysis and investors as they help not only in determining the effectiveness of a company in utilizing its resources but also in pinpointing areas where it can enhance its operations. These ratios can also be used to benchmark the performance of a company against its peers or competitors in the industry.

**Below are the key efficiency ratios used in fundamental analysis:**

**• Asset Turnover Ratio:** Measures how well a company is using its assets to generate sales. This is similar to ROA but is computed by dividing revenue by total assets. A high ratio indicates better asset management. Investors use this financial ratio to assess whether a company is making the most out of its investments in assets and allow them to compare asset utilization across different companies.

**• Inventory Turnover Ratio:** Measures how often a particular company sells and replaces its inventory over a period to determine the efficiency of inventory movement and control. It essentially reflects the demand for the products of the company. A high ratio might signal strong sales. A low turnover ratio might be an indicator of either low sales from low demand or overproduction and overstocking.

**• Receivable Turnover Ratio:** Measures how efficiently a company collects its accounts receivable over a period and reveals the effectiveness of its accounts management and credit policies. This is computed by dividing net credit sales by average account receivables. A high ratio is an indicator of efficient collection and better cash flow and a low ratio might indicate potential credit risks.

**5. Valuation Ratios**

The financial metrics that are used to compare the stock price of a company to its fundamental financial performance or assets are called valuation ratios. These ratios specifically measure the relationship between the market value of a company or equity and some fundamental financial metrics that can be obtained from its financial statements.

Both tenured investors and analysts use valuation ratios to generate insights into whether a stock of a company is overvalued, undervalued, or fairly valued. These ratios are essential tools in fundamental analysis and are widely used to make investment decisions about buying, holding, or selling stocks or to inform growth or value strategies.

**Below are the key valuation ratios used in fundamental analysis:**

**• Price-to-Earnings Ratio:** Compares the stock price of a company to its earnings per share. It is used to assess earnings valuation and growth expectations. This is computed by dividing market price per share by earnings per share. A high ratio may indicate that the stock is overvalued and a low ratio could suggest it is undervalued.

**• Price-to-Book Ratio:** Compares the stock price of a company to its book value or net asset value per share. This is computed by dividing market price per share by book value per share. A ratio below 1 may indicate that the stock is undervalued relative to its assets. This means that the market might be undervaluing its assets.

**• Price-to-Sales Ratio:** Compares the stock price of a company or its market capitalization to its revenues. This is computed by dividing market price per share by revenue per share. A lower ratio may be indicative of undervaluation of a stock relative to its revenue and a higher ratio might suggest overvaluation or strong growth.

**• EV-to-EBITDA Ratio:** Provides a more comprehensive valuation than price-to-earnings ratio by factoring in both equity and debt. It is useful for comparing companies with different capital structures. This is computed by dividing enterprise value by earnings before interest, taxes, depreciation, and amortization.

**• Dividend Yield:** Measures the annual dividend per share relative to the stock price. This is computed by dividing annual dividends per share by market price per share and multiplying the result by 100. The dividend yield specifically measures the return on investment from dividends alone. This is useful for income-seeking investors.