Accounting Science

How to Evaluate Company Financial Performance Evaluation of Companies Using Financial Ratios

Posted by

mariam elghandour

March 13, 2025

On February 18, 2025

Assessing the financial performance of companies is crucial for understanding their financial health and operational efficiency, and for making informed investment and financing decisions. Financial ratios, extracted from financial statements, provide effective tools for analyzing a company’s performance and identifying its strengths and weaknesses. In this article, we will explain how to perform Financial Performance Evaluation of Companies using financial ratios, classify these ratios into key groups, provide a detailed explanation of the most important ratios in each group (including formulas and interpretations), and highlight the importance of financial performance evaluation and its impact on the decisions of investors and stakeholders.

What are Financial Ratios?

Financial ratios are mathematical relationships between two or more items from the financial statements, used to measure various aspects of an entity’s performance and financial position. Financial ratios help transform raw financial data into meaningful information that can be used to assess the company’s performance and compare it with its competitors or industry averages.

The Importance of Financial Ratios in the Financial Performance Evaluation of Companies:

Provides a Quick Overview of Company Performance: Financial ratios provide a quick and easy summary of a company’s performance in various areas, such as profitability, liquidity, and efficiency.
Helps Identify Trends: Financial ratios can be compared across different time periods to identify performance trends and analyze changes in the company’s performance.
Facilitates Comparison Between Companies: Financial ratios enable the comparison of the performance of different companies in the same industry, even if they are of different sizes.
Helps in Decision-Making: Financial ratios provide valuable information that helps investors, creditors, and management make informed decisions. The outputs are critical to overall Financial Performance Evaluation of Companies.
Reveals Strengths and Weaknesses: Financial ratios help identify strengths and weaknesses in the company’s performance, which helps management take corrective action.
Used in Forecasting Future Performance: Financial ratios, along with other analytical tools, can be used to forecast the company’s future performance.

Classification of Financial Ratios:

Financial ratios can be classified into main groups according to the information they provide:

Profitability Ratios:
- Definition: Measure the entity’s ability to generate profits.
- Key Ratios:
  - Gross Profit Margin:
    - Formula: (Gross Profit / Sales Revenue) × 100%
    - Interpretation: Indicates the percentage of profit the entity makes from each Riyal of sales after deducting the cost of goods sold. It reflects the entity’s efficiency in managing production or purchasing costs.
  - Net Profit Margin:
    - Formula: (Net Profit / Sales Revenue) × 100%
    - Interpretation: Indicates the percentage of profit the entity makes from each Riyal of sales after deducting all expenses, including taxes. It represents the entity’s final profitability.
  - Operating Profit Margin:
    - Formula: (Operating Profit / Sales Revenue) × 100%
    - Interpretation: Indicates the entity’s efficiency in managing its core operations and generating profits from its main activities.
  - Return on Assets (ROA):
    - Formula: (Net Profit / Average Total Assets) × 100%
    - Interpretation: Indicates the entity’s efficiency in using its assets to generate profits. It can also be calculated using operating profit instead of net profit.
  - Return on Equity (ROE):
    - Formula: (Net Profit / Average Total Equity) × 100%
    - Interpretation: Indicates the return that shareholders earn on their investments in the entity.
Liquidity Ratios:
- Definition: Measure the entity’s ability to meet its short-term obligations.
- Key Ratios:
  - Current Ratio:
    - Formula: Current Assets / Current Liabilities
    - Interpretation: Indicates the number of times current assets cover current liabilities. The higher the ratio, the better the liquidity. A ratio above 1 is generally preferred.
  - Quick Ratio (Acid-Test Ratio):
    - Formula: (Current Assets – Inventory) / Current Liabilities
    - Interpretation: A more conservative measure of liquidity than the current ratio, as it excludes inventory from current assets. It indicates the entity’s ability to meet its short-term obligations without relying on the sale of inventory. A ratio above 1 is generally preferred.
  - Cash Ratio:
  - Interpretation It is the most conservative, measuring the company’s ability to settle it’s current liabilities only using cash and short-term investments.
Solvency Ratios:
- Definition: Measure the entity’s ability to meet its long-term obligations. These ratios are crucial to the long-term view in Financial Performance Evaluation of Companies.
- Key Ratios:
  - Debt-to-Equity Ratio:
    - Formula: Total Liabilities / Total Equity
    - Interpretation: Indicates the extent to which the entity relies on debt to finance its assets. The higher the ratio, the higher the financial risk.
  - Debt Ratio:
    - Formula: Total Liabilities / Total Assets
    - Interpretation: Indicates the proportion of assets financed by debt.
  - Fixed Asset Coverage Ratio
    - Formula: Net Fixed Assets / Long Term Liabilities.
    - Interpretation: Indicated the adequacy of fixed assets to cover Long Term Liabilities.
  - Times Interest Earned Ratio:
    - Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense
    - Interpretation: Indicates the entity’s ability to cover interest expenses from its operating profit.
Efficiency Ratios (Activity Ratios):
- Definition: Measure the entity’s efficiency in managing its assets and operations. Efficiency is a key component of a robust Financial Performance Evaluation of Companies.
- Key Ratios:
  - Inventory Turnover Ratio:
    - Formula: Cost of Goods Sold / Average Inventory Balance
    - Interpretation: Indicates the number of times inventory is sold and replaced during the period. The higher the ratio, the better the inventory management efficiency.
  - Accounts Receivable Turnover Ratio:
    - Formula: Net Credit Sales / Average Accounts Receivable
    - Interpretation: Indicates the number of times receivables are collected during the period. The higher the ratio, the better the debt collection efficiency.
  - Days Sales Outstanding (DSO):
    - Formula: (Average Accounts Receivable / Net Credit Sales) × Number of Days in Period
    - Interpretation: Indicates the average number of days it takes the entity to collect its receivables from customers.
  - Fixed Asset Turnover Ratio:
    - Formula: Net Sales / Average Net Fixed Assets
    - Interpretation: Indicates the entity’s efficiency in using its fixed assets to generate sales.
  - Total Asset Turnover Ratio:
    - Formula: Net Sales / Average Total Assets
    - Interpretation: Indicates the entity’s efficiency in using all its assets to generate sales.
Market Ratios:
- Definition: Measure the entity’s performance in the stock market.
- Key Ratios:
  - Earnings Per Share (EPS):
    - Formula: Net Profit / Number of Outstanding Common Shares
    - Interpretation: Indicates the profit per share of common stock.
  - Price-to-Earnings Ratio (P/E Ratio):
    - Formula: Market Price Per Share / Earnings Per Share
    - Interpretation: Indicates the number of years needed to recover the share price through the company’s earnings.
  - Dividend Payout Ratio:
    - Formula: Dividends Per Share / Earnings Per Share
    - Interpretation: Indicates the proportion of earnings that the company distributes to shareholders.

Steps for Financial Performance Evaluation of Companies Using Financial Ratios:

Define the Objectives of the Analysis: Clearly define the objectives of the analysis, such as assessing profitability, liquidity, or solvency.
Select Appropriate Financial Ratios: Choose the financial ratios that are appropriate for the objectives of the analysis and the nature of the entity’s business.
Collect Financial Data: Collect the necessary financial data to calculate the financial ratios from the entity’s financial statements.
Calculate Financial Ratios: Calculate the financial ratios using the appropriate formulas.
Analyze and Interpret Financial Ratios: Analyze the financial ratios individually and collectively to understand the entity’s performance and financial position. Compare the financial ratios with industry averages and with the entity’s performance in previous periods.
Identify Strengths and Weaknesses: Identify strengths and weaknesses in the entity’s performance based on the analysis of financial ratios. This is a critical step in a thorough Financial Performance Evaluation of Companies.
Take Corrective Action: Management should take necessary corrective action to address any weaknesses identified through the analysis.

The Importance of Financial Performance Evaluation of Companies:

Financial Performance Evaluation of Companies is extremely important for the following reasons:

Making Investment Decisions: Evaluation helps investors make informed decisions about buying, selling, or holding company shares.
Making Credit Decisions: Evaluation helps creditors assess credit risk and make decisions about granting loans and their terms.
Evaluating Management Performance: The results of the evaluation can be used to measure management’s efficiency in achieving the entity’s objectives.
Identifying Improvement Opportunities: Evaluation helps identify areas that can be improved to increase profitability and efficiency.
Planning for the Future: The results of the evaluation can be used to develop financial and strategic plans for the future.
Measuring Company Value: Evaluation helps determine the fair value of the company, which is important in cases of mergers and acquisitions. Valuation will rely heavily on the Financial Performance Evaluation of Companies.

Ethical Considerations in the Financial Performance Evaluation of Companies:

Financial performance evaluation must be conducted with integrity, objectivity, and transparency. Financial analysts must adhere to the highest standards of ethical conduct and avoid any conflicts of interest. Any biases or limitations that may affect the results of the evaluation must be disclosed.

The Role of Technology in Financial Performance Evaluation:

Accounting software, Enterprise Resource Planning (ERP) systems, and data analysis tools provide many advantages that facilitate the financial performance evaluation process, such as:

Automating the calculation of financial ratios.
Creating graphs and charts that show trends in financial ratios over time.
Performing comparative analyses with other entities in the same industry. Benchmarking is a very useful technique in Financial Performance Evaluation of Companies.
Identifying strengths and weaknesses in the entity’s financial performance.
Forecasting future financial performance based on historical data.

Conclusion:

Financial Statement Analysis is an essential tool for understanding an entity’s performance and financial position. Horizontal and vertical analysis, combined with financial ratios, provide valuable insights into profitability, liquidity, solvency, and efficiency. Mastering these analytical skills is crucial for investors, creditors, and management to make informed decisions. Technology greatly facilitates this process, improving the quality and accuracy of financial information. For a deeper understanding of the fundamentals, you can refer to the article: Fundamentals of Financial Analysis for Startups .