What is a financial ratio?

A financial ratio is a calculation derived from a company’s financial statements that provides insights into its performance, financial health, and operational efficiency. These ratios allow analysts, investors, and managers to evaluate various aspects of a business, such as profitability, liquidity, and leverage. By comparing these ratios over time or against industry benchmarks, stakeholders can identify trends, assess risks, and make informed decisions regarding investments or management strategies.

For instance, common financial ratios include the current ratio, which assesses liquidity by comparing current assets to current liabilities, and the return on equity (ROE), which measures profitability relative to shareholders' equity. These calculations are key tools in financial analysis, facilitating a deeper understanding of how well a company is managing its resources and generating income.

In contrast, a legal agreement between two parties does not reflect the financial performance of a company. Estimating business valuation relies on various methods, including financial ratios but extends beyond them, incorporating market conditions and potential future earnings. Lastly, a record of the company’s net worth, while important, does not encompass the broader analytical insights provided by financial ratios, which weigh multiple figures from financial statements to evaluate overall company performance.