How to Evaluate Financial Performance

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Financial statement analysis is the most objective way to evaluate the financial performance of a company. Financial analysis involves assessing the leverage, profitability, operational efficiency and solvency for a company. Financial ratios are the principle tool used to conduct the analysis. The challenge is knowing which ratios to choose from and how to interpret the results.

  • Calculate and analyze liquidity ratios. The two principal liquidity ratios are the current ratio and the quick ratio. The current ratio is current assets divided by current liabilities. The quick ratio is more conservative as it excludes inventory and other current assets from the numerator. In general, the higher the ratio the stronger the liquidity position.

  • Calculate and analyze efficiency ratios. The two principal efficiency ratios are fixed asset turnover and sales per revenue. The ratio is defined as revenues divided by property, plant and equipment (PPE) and measures a firm's ability to turn fixed assets into sales. Sales per employee is calculated as read. The higher the dollar amount per employee, the better.

  • Calculate and analyze leverage ratios. The two principal leverage ratios are debt to equity and debt to assets. Both compare a company's ability to pay off debt with a dollar of assets or equity. The debt-to-equity ratio equals total liabilities divided by shareholders' equity and the debt-to-assets ratio equals total liabilities divided by total assets. In general, the higher the ratio, the higher the risk.

  • Calculate and analyze profitability ratios. The two primary profitability ratios are return on assets (ROA) and return on equity (ROE). ROA is a measure of how much a dollar invested in assets creates a dollar in sales; ROE is a measure of how much a dollar invested by shareholders creates a dollar in sales. ROA equals net income divided by average total assets and ROE equals net income divided by average shareholders' equity. In general, the higher the percentage the better.

  • Compare against industry standards. While these ratios provide a great deal of insight into a company's financial performance, it helps to compare with peers in the industry. This will also highlight strengths and weaknesses within the firm.

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