Three Categories of Financial Ratios
Financial ratios fall into three groups. Profitability ratios (ROE, ROA, operating margin) measure how efficiently a company generates profit. Solvency ratios (debt-to-equity, current ratio, interest coverage) assess bankruptcy risk. Efficiency ratios (asset turnover, inventory turnover) show how well a company uses its resources. No single ratio tells the full story; combining multiple ratios across categories provides a comprehensive picture.
Industry Context Matters
Ratios must be compared within the same industry. A 5% operating margin is average for manufacturing but poor for software companies. Banks naturally carry extreme leverage that would signal danger in other sectors. ROE above 20% is generally excellent, but if driven by excessive debt rather than operational efficiency, it masks underlying risk. Always check the debt-to-equity ratio alongside ROE to distinguish genuine profitability from financial engineering.
Essential Ratios for Individual Investors
Focus on four key metrics: ROE (capital efficiency), operating margin (core business profitability), equity ratio (financial stability), and free cash flow (actual cash generation). Review these over a five-year trend rather than a single snapshot. Improving trends in these four ratios indicate a strengthening business, while deteriorating trends are warning signs regardless of the current stock price.