How to Interpret Financial Ratios

by Jessica Kent

Company owners and investors often use financial ratios to analyze a company’s performance. Ratios for the current period are compared with ratios in prior years to determine developing trends. Ratios are also compared to industry surveys and benchmarks to assess a company’s performance in its industry sector. The Risk Management Association's Annual Statement Studies publishes financial ratios annually based on industry, assets owned and amount of revenue. When a company is not performing to expectations or industry benchmarks, ratios are an invaluable resource for pinpointing areas of financial difficulty.


Evaluate asset turnover ratios, such as accounts receivable turnover and inventory turnover, to determine how efficiently assets are being utilized by the business. The average collection period for accounts receivable turnover indicates the number of days it generally takes to collect revenue from credit sales. A greater collection period indicates trouble with a company’s credit and collection policies. The longer inventory remains in a company’s warehouse, the more likely it will be outdated and subject to obsolescence. This can be determined by calculating the average inventory period.


Calculate profitability ratios such as gross profit margin, return on assets and return on equity to determine how well a company is performing over time. Compare the company’s ratios to industry benchmarks to determine if the company is underperforming, exceeding industry standards or remaining on par with the industry.


Analyze a company’s financial leverage ratios to determine its long-term solvency. Solvency, especially in light of the current economy, is of utmost concern to owners and investors alike. A value of less than 1.0 obtained for ratios such as debt to total assets or debt to equity is considered to be within normal limits. Financial leverage ratios are dependent on the way a company classifies short-term and long-term debt.


Determine a company’s ability to pay short-term debt using liquidity ratios such as the current ratio and the quick ratio. A figure greater than 1.0 for these ratios indicates the company has sufficient assets to cover short-term debt obligations. A greater liquidity ratio indicates less risk for creditors. However, a lower liquidity ratio is generally preferred by shareholders because it indicates that assets are being used to fund and expand a company’s operations.

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