A ratio is a comparison of one number to another. The concept is commonly used in financial analysis to gain insights into the financial performance, condition, and cash flows of an organization. This is done by comparing the numbers in an entity's financial statements to each other. For example:
- The current ratio compares current assets to current liabilities to estimate the ability of a business to pay its invoices from suppliers.
- The debt to equity ratio is used to determine the amount of higher-risk debt that a business has taken on in comparison to the equity investment of its shareholders.
- The gross margin ratio compares revenues to the gross margin to discern the amount of profitability that a company's products generate.
Ratio analysis can also be used outside of a company's financial statements. For example, the price/earnings ratio compares a company's stock price to its net income to see if the stock is properly valued.