How to Use Financial Ratios

There are several important numbers to key in on. Some ratios can be useful by themselves. Others are completely useless when considered without context. Typically, financial ratios provide the most benefit when they are compared with other identical ratios.

Compare over time

A company's ratios are used comparatively in two main fashions: over time and against other companies. Comparing the same ratios for a firm over time is a great way to identify a company's trends. If certain ratios are steadily improving, this may suggest an improvement in a company's operations or financial situation; conversely, if certain ratios seem to be getting worse, they may highlight some troubling prospects about the firm.

Compare industries

It's also important to compare a company's ratios against those of others in the industry. A company's ratios may be improving over time, but how do they stack up against their peers' ratios? If they aren't as rosy as those of competitors, this may indicate that the company isn't as well positioned or managed as well as other industry players.

Financial analysts evaluate many ratios as they perform their analyses. Four of the major types to consider are efficiency ratios, liquidity ratios, leverage ratios, and profitability ratios. Each of the main ratios within each category measures something different and indicates different types of changes.