How to Evaluate Financial Ratios

by Jonathan Roe ; Updated July 27, 2017

Items you will need

  • Calculator
  • Current financial statements
  • Comparative industry ratios

Analyzing financial ratios can provide insight into a company’s strengths, weaknesses, competitive advantages and strategy. While different industries can have wildly different ratios, comparing ratios of companies within the same industry is one way to dig further into a company’s true performance.

Calculate Common Ratios

Step 1

Divide current assets by current liabilities. This ratio represents the company’s current ratio and reflects its ability to pay its debts for the coming year. This ratio needs to be over 1.00.

Step 2

Add together all of the company’s funded debt and then divide by the trailing 12-month period EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). This ratio represents cash flow leverage. Think about it in terms of how much money you make versus how big a mortgage you have. For a company, you typically want this ratio to be under 4.50.

Step 3

Divide annual sales by the amount of inventory listed on the balance sheet. This represents the number of inventory turns, and gives an indication as to how lean and efficient the company runs. Typically, the higher the number the better, as long as it is not taken to extremes.

Step 4

Divide EBITDA by annual sales. This represents the company’s margins. You want them to be as large as possible.

Evaluate Common Ratios

Step 1

Repeat the above Steps for the company’s top five competitors. This will give you a range of values for each ratio that is specific to the company’s industry. This is important because different industries have different ranges for ratios due to the nature of their business.

Step 2

Identify the key ratios that drive profitability. For example, a distributor or wholesaler will want to have a high number of inventory turns, while an investment bank will want to have a high level of leverage.

Step 3

Rank order the values of the different ratios. Based on the company's rank for the different ratios, you can determine their strengths, weaknesses and strategies.

Tips

  • The ratios above are only examples of common financial ratios. This method can be applied to any ratio, and thought should be given as to which financial ratios are the key drivers of a firm’s profitability.

Warnings

  • For meaningful results, it is important to only compare companies that are in the same industry.

About the Author

Jonathan Roe enjoyed a liberal arts education at Miami University where he studied philosophy and business. He is currently working on an MBA at the Weatherhead School of Management in Cleveland, Ohio, while working full time as a corporate banker. Relying on his wide-ranging education, he writes for a variety of companies.