Financial Ratios: How to Measure a Company's Performance
Financial statements show what a company earned, owns, and owes, but the numbers on their own are hard to judge. $120,000 in net income could be excellent or terrible depending on the size of the business. Financial ratios express those numbers as percentages and multiples that are comparable across companies and time periods.
Key takeaway: A single ratio means little on its own. Ratios become useful when you compare them to prior periods, competitors, or industry benchmarks.
The Financial Statements
All ratios in this guide come from one company. Here is a simplified balance sheet and income statement for a mid-size manufacturer.
Balance Sheet (Assets):
| Amount | |
|---|---|
| Cash | $80,000 |
| Accounts Receivable | $120,000 |
| Inventory | $200,000 |
| Total Current Assets | $400,000 |
| Property & Equipment | $600,000 |
| Total Assets | $1,000,000 |
Balance Sheet (Liabilities & Equity):
| Amount | |
|---|---|
| Accounts Payable | $100,000 |
| Short-term Debt | $100,000 |
| Total Current Liabilities | $200,000 |
| Long-term Debt | $300,000 |
| Total Liabilities | $500,000 |
| Total Equity | $500,000 |
Income Statement:
| Amount | |
|---|---|
| Revenue | $1,200,000 |
| Cost of Goods Sold | $720,000 |
| Gross Profit | $480,000 |
| Operating Expenses | $280,000 |
| EBIT (Operating Income) | $200,000 |
| Interest Expense | $40,000 |
| Pretax Income | $160,000 |
| Taxes (25%) | $40,000 |
| Net Income | $120,000 |
Liquidity Ratios
Liquidity ratios measure whether a company can pay its short-term obligations. The two standard ones are the current ratio and the quick ratio.
Current ratio divides total current assets by total current liabilities:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = $400,000 / $200,000 = 2.0
A current ratio of 2.0 means the company has $2 in current assets for every $1 in current liabilities. Above 1.0 is generally considered healthy. Well below 1.0 signals the company may struggle to cover near-term bills.
Quick ratio (also called the acid-test ratio) strips out inventory, since inventory is the hardest current asset to convert to cash quickly:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Quick Ratio = ($400,000 - $200,000) / $200,000 = 1.0
A quick ratio of 1.0 means the company can cover its current liabilities entirely from cash and receivables, without selling any inventory.
The gap between the current ratio (2.0) and the quick ratio (1.0) tells you that half of this company's current assets are tied up in inventory. For a manufacturer, that is typical. For a software company, it would be unusual.
Profitability Ratios
Profitability ratios measure how effectively a company turns revenue and assets into profit.
Net profit margin shows how much of each revenue dollar the company keeps after all expenses:
Net Profit Margin = Net Income / Revenue
Net Profit Margin = $120,000 / $1,200,000 = 10%
For every dollar of revenue, this company keeps $0.10 as profit after costs, interest, and taxes.
Return on assets (ROA) measures how efficiently the company uses its asset base:
ROA = Net Income / Total Assets
ROA = $120,000 / $1,000,000 = 12%
Each dollar of assets generates $0.12 in net income.
Return on equity (ROE) measures the return delivered to shareholders:
ROE = Net Income / Total Equity
ROE = $120,000 / $500,000 = 24%
ROE is 24%, exactly double the 12% ROA. The gap exists because the company uses debt to amplify returns on equity. With $500,000 in equity controlling $1,000,000 in assets, each dollar of profit is measured against a smaller equity base. More leverage widens the gap between ROA and ROE, which is good when the company is profitable and dangerous when it is not.
Leverage Ratios
Leverage ratios measure how much debt a company carries and whether it can service that debt.
Debt-to-equity ratio compares total interest-bearing debt to shareholders' equity:
Debt-to-Equity = Total Debt / Total Equity
Debt-to-Equity = $400,000 / $500,000 = 0.8
Total debt is short-term debt ($100,000) plus long-term debt ($300,000). A D/E of 0.8 means the company has $0.80 in debt for every $1.00 of equity. Below 1.0, equity is the larger share of funding. Above 2.0 signals heavy leverage, though acceptable levels vary widely by industry. Banks routinely operate above 5.0, while software companies often sit below 0.5.
Interest coverage ratio measures how comfortably a company can pay its interest charges from operating income:
Interest Coverage = EBIT / Interest Expense
Interest Coverage = $200,000 / $40,000 = 5.0
EBIT covers interest five times over. Above 3.0 is generally considered safe. Below 1.5 raises concerns about the company's ability to meet its debt obligations if earnings decline.
Why Financial Ratios Matter
Here are all seven ratios from the same set of financial statements:
| Category | Ratio | Result |
|---|---|---|
| Liquidity | Current Ratio | 2.0 |
| Liquidity | Quick Ratio | 1.0 |
| Profitability | Net Profit Margin | 10% |
| Profitability | ROA | 12% |
| Profitability | ROE | 24% |
| Leverage | Debt-to-Equity | 0.8 |
| Leverage | Interest Coverage | 5.0 |
Together, these describe a company in solid financial shape: liquid enough to cover its obligations, profitable relative to its size, and moderately leveraged with comfortable interest coverage. But a single snapshot only goes so far. Comparing these ratios to prior years shows whether performance is improving or deteriorating. Comparing to competitors shows whether the company is ahead or behind its peers.
Financial ratios show up across the field:
- Equity research: Analysts compare a company's ratios to its peers to assess relative valuation.
- Credit analysis: Lenders focus on leverage and coverage ratios when setting loan terms.
- Internal management: Executives track margins and returns over time to spot deteriorating trends early.
- Due diligence: In M&A, acquirers use ratios to identify strengths and risks in the target company.
Conclusion
Liquidity ratios measure whether a company can pay its bills. Profitability ratios measure how well it converts revenue and assets into earnings. Leverage ratios show how much debt it carries and whether it can service it. Together they give you a financial profile from three angles.
To see how ROE breaks down into its underlying drivers, see our guide on DuPont analysis. For the discount rate that connects to many of these metrics, see our guide on WACC. For the investment decisions that ratio analysis informs, see our guide on NPV and IRR.
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