# Understanding Financial Ratios to Assess Performance

Financial ratios are powerful tools used to assess the performance of a business. They provide a snapshot of a company’s financial health, enabling investors and analysts to make informed decisions. Financial ratios measure a company’s profitability, liquidity, solvency, efficiency, and other financial metrics.

To get a better understanding of how to use financial ratios to assess performance, let’s first look at the different types of ratios used.

Profitability Ratios measure how well a company is performing in terms of its ability to generate profits. These ratios include gross profit margin, operating profit margin, return on assets, and return on equity.

Gross profit margin is the amount of revenue left after subtracting the cost of goods sold. This ratio shows the company’s ability to generate profits from its sales.

Operating profit margin is the amount of revenue left after subtracting the cost of goods sold, operating expenses, and taxes. This ratio shows how much of a company’s revenue is left after all costs are taken into account.

Return on assets measures a company’s ability to generate profits from its assets. This ratio shows the return on a company’s total assets.

Return on equity measures a company’s ability to generate profits from its owners’ investments. This ratio shows the return on a company’s owner’s equity.

Liquidity Ratios measure a company’s ability to pay its short-term obligations. These ratios include current ratio, quick ratio, and cash ratio.

Current ratio is the amount of current assets divided by current liabilities. This ratio shows a company’s ability to pay its short-term obligations with its current assets.

Quick ratio is the amount of current assets minus inventory divided by current liabilities. This ratio shows a company’s ability to pay its short-term obligations without relying on its inventory.

Cash ratio is the amount of cash and cash equivalents divided by current liabilities. This ratio shows a company’s ability to pay its short-term obligations with its cash and cash equivalents.

Solvency Ratios measure a company’s ability to meet its long-term obligations. These ratios include debt to equity ratio and interest coverage ratio.

Debt to equity ratio is the amount of total liabilities divided by total equity. This ratio shows a company’s ability to pay its long-term obligations with its equity.

Interest coverage ratio is the amount of earnings before interest and taxes divided by interest expense. This ratio shows a company’s ability to meet its interest payments.

Efficiency Ratios measure a company’s ability to use its resources efficiently. These ratios include asset turnover ratio, inventory turnover ratio, and accounts receivable turnover ratio.

Asset turnover ratio is the amount of sales divided by total assets. This ratio shows a company’s ability to generate sales from its assets.

Inventory turnover ratio is the amount of cost of goods sold divided by average inventory. This ratio shows a company’s ability to manage its inventory.

Accounts receivable turnover ratio is the amount of sales divided by average accounts receivable. This ratio shows a company’s ability to collect on its accounts receivable.

By understanding these financial ratios, investors and analysts can gain valuable insights into a company’s performance. By comparing these ratios to industry averages and trends, investors and analysts can make more informed decisions. Financial ratios provide a snapshot of a company’s financial health, enabling investors and analysts to assess performance and make informed decisions.