How to Use Financial Ratios to Assess Business Performance

Investors, managers and stakeholders need to understand the financial health of a business. One of the best tools to measure a business performance is through financial ratios. By calculating these ratios and comparing them to industry benchmarks or historical trends, you can see how profitable, liquid, efficient and stable a company is.

In this article, we will go into detail on how to use financial ratios to measure business performance, provide examples from real companies and explain how each ratio works in practice.

What are Financial Ratios?

Financial ratios are calculated using values from a company’s financial statements such as income statement, balance sheet and cash flow statement. These ratios simplify complex financial information and allow you to measure different aspects of a business’s financial health. For example ratios can show whether a company is making enough profit, how it’s using its resources or if it can meet its short term and long term financial obligations.

Example

Let’s take XYZ Retail Inc., a mid-sized retail chain with 50 outlets. The management team wants to know if they should open 10 new stores in the next financial year. To make this decision they will use financial ratios to measure the company’s liquidity, profitability and efficiency.

By using financial ratios the management team can see if XYZ Retail Inc. is financially strong enough to support the expansion and if the current stores are running efficiently. Let’s go into detail on each ratio and apply them to XYZ Retail’s scenario.

Financial Ratios

There are 4 types of financial ratios:

1. Liquidity Ratios: How well can a business pay its short term debts.
2. Profitability Ratios: How well does a business make profit.
3. Leverage Ratios: How much does a business rely on debt.
4. Efficiency Ratios: How well does a business use its resources to generate revenue.

Let’s get into each category with explanations and examples.

1. Liquidity Ratios

Liquidity ratios help us see if a company can pay its short term obligations without raising more capital. These ratios are important to see if a company can cover its expenses coming up like accounts payable, wages and other short term liabilities.

Current Ratio

The current ratio is the most widely used liquidity ratio. It sees if a company has enough short term assets (cash, receivables and inventory) to cover its short term liabilities.

Current Ratio = Current Assets / Current Liabilities

Interpretation: A current ratio more than 1 means the company has more current assets than current liabilities, good liquidity. Less than 1 may be liquidity issues.

Example: For XYZ Retail Inc., suppose current assets (cash, inventory and receivables) are $1,500,000 and current liabilities (short term debt and accounts payable) are $1,000,000

Current Ratio = 1,500,000 / 1,000,000 = 1.5

So 1.5 means XYZ Retail has $1.50 for every $1 of current liabilities. Good for expansion, the company can cover unexpected expenses.

Quick Ratio (Acid-Test Ratio)

The quick ratio provides a tighter measure of liquidity by excluding inventory from current assets. Inventory is excluded because it may not be easily convertible to cash in the short term.

Quick Ratio = (Current Assets − Inventories) / Current Liabilities

Interpretation: A higher quick ratio means the company can pay off its short term liabilities without selling its inventory.

Example: XYZ Retail has current assets of $1,500,000 out of which inventory is $700,000 and current liabilities of $1,000,000

Quick Ratio = (1,500,000 − 700,000) / 1,000,000 = 0.8

With a quick ratio of 0.8, XYZ Retail may have liquidity problems if it can’t convert its inventory into cash quickly.

2. Profitability Ratios

Profitability ratios show how well a company makes profit relative to its sales, assets or equity. These are the numbers investors look at to see if the business can deliver.

Net Profit Margin

Net profit margin is how much of a company’s sales is turned into profit after all expenses are accounted for including taxes and interest.

Net Profit Margin = (Net Profit / Revenue) × 100

Interpretation: Higher net profit margin means better profitability and cost management.

Example: If XYZ Retail has a net profit of $100,000 and revenue of $1,000,000:

Net Profit Margin = (100,000 / 1,000,000) × 100 = 10%

This 10% margin means XYZ Retail makes $0.10 for every dollar of sales, which is good for the retail industry.

Return on Assets (ROA)

Return on Assets (ROA) measures how well a company uses its assets to make profit.

ROA = (Net Profit / Total Assets) × 100

Interpretation: Higher is better.

Example: For XYZ Retail, if net profit is $100,000 and total assets are $2,000,000

ROA = (100,000 / 2,000,000) × 100 = 5%

So, a ROA of 5% means for every dollar invested in assets, XYZ Retail makes $0.05. Industry average is 4% so XYZ is doing well.

3. Leverage Ratios

Leverage ratios show how much of a company’s operations are funded by debt compared to equity. High leverage ratios can indicate greater risk but also potential for higher returns.

Debt-to-Equity Ratio

The debt-to-equity ratio measures the proportion of debt financing relative to equity financing.

Debt-to-Equity Ratio = Total Debt / Total Equity

Interpretation: A high debt-to-equity ratio means a business is using more debt relative to equity, which can increase financial risk.

Example: Suppose XYZ Retail has $600,000 in debt and $400,000 in equity.

Debt-to-Equity Ratio = 600,000 / 400,000 = 1.5

This ratio of 1.5 means XYZ uses $1.50 in debt for every $1 of equity. If the industry average is 1.0, XYZ Retail is more leveraged than its peers, which might concern investors.

Interest Coverage Ratio

The interest coverage ratio shows how easily a company can pay interest on debt.

Interest Coverage Ratio = EBIT / Interest Expense

Interpretation: Less than 1 means the business can’t pay interest.

Example: For XYZ Retail, if EBIT is $120,000 and interest expense is $30,000

Interest Coverage Ratio= 120,000 / 30,000 = 4

So XYZ Retail can pay 4 times its interest expenses, which is good.

4. Efficiency Ratios

Efficiency ratios, also known as activity ratios, measure how effectively a company uses its assets and manages its liabilities. These ratios are particularly relevant in industries where operational efficiency directly impacts profitability, such as manufacturing and retail.

Inventory Turnover Ratio

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period. A high inventory turnover ratio indicates that a company is selling inventory quickly, which is usually a good sign of strong sales performance or efficient inventory management.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Interpretation: A high ratio indicates efficient inventory management, while a low ratio may signal overstocking or weak sales.

Example: Assume XYZ Retail’s cost of goods sold is $800,000, and its average inventory over the year is $200,000

Inventory Turnover Ratio = 800,000 / 200,000 = 4

This means XYZ Retail sells and replaces its entire inventory four times a year. If the industry average is 6.0, XYZ Retail may be overstocking or struggling to move inventory, which could lead to higher holding costs.

Asset Turnover Ratio

The asset turnover ratio shows how well a company is using its assets to generate sales.

Asset Turnover Ratio = Net Sales / Total Assets

Interpretation: High is good, low is bad.

Example: XYZ Retail has net sales of $3,000,000 and total assets of $1,500,000

Asset Turnover Ratio = 3,000,000 / 1,500,000 = 2

This is 2 to 1. So for every dollar invested in assets, XYZ generates $2. Industry average is 1.5 so XYZ is using its assets better than its competitors which is good for investors.

Using Financial Ratios for Business Analysis

Financial ratios are powerful but only as powerful as how you use them together. For a full business analysis:

• Context is Everything: Compare to industry standards and historical trends to avoid false conclusions.
• Use a Mix of Ratios: Different ratios can work together.
• Know the Industry: The ideal ratio varies by industry.

Conclusion

To make informed investment and management decisions, you need to understand how to use financial ratios. Whether you’re looking at liquidity, profitability, leverage or efficiency, each ratio gives you a different view of the business. Always look at the bigger picture, cross reference different ratios and industry standards to get the best view of the business. 👀️ 💡️