Financial Ratios: How to Diagnose Your Company’s Performance and Uncover Strengths and Weaknesses

Executive Summary

Large figures in financial statements can sometimes be misleading. A profit of one million riyals may be outstanding for a small company, yet disastrous for a large one.

This is where financial ratios come in. They are the tools that allow us to compare performance over time and benchmark a company against its competitors in the market.

This article explains the most important financial indicators every manager and decision maker needs to evaluate liquidity, profitability, and operational efficiency turning raw data into actionable strategic insights.

Key Ratios Glossary

What It Measures

Term 
The company’s ability to meet short-term obligations Liquidity Ratios
Management’s effectiveness in using company resources (assets and inventory) Profitability Ratios
Management’s effectiveness in using company resources (assets and inventory) Efficiency Ratios
The extent to which the company relies on debt to finance operations Leverage Ratios

1. Liquidity Ratios: Is Your Company Safe?

Liquidity is the first line of defense against bankruptcy.

The two most important ratios are:

  • Current Ratio: Measures the ability of current assets to cover current liabilities.
    The ideal level is often around 2:1, though it varies by industry.

  • Quick Ratio: A stricter test of liquidity that excludes inventory, since inventory may not be easily converted to cash.

2. Profitability Ratios: Are You Reaping the Rewards?

Profit is the fuel for growth, and these ratios reveal the quality of that fuel:

  • Gross Profit Margin: Shows the percentage of sales remaining after deducting direct production costs.

  • Return on Assets (ROA): Indicates how many riyals of profit are generated by each riyal invested in assets.

  • Return on Equity (ROE): The most important metric for owners; it measures the return generated on shareholders’ funds.

3. Efficiency and Activity Ratios: Are Your Resources Working Smart?

This is where we assess management’s skill in “keeping money moving”:

  • Inventory Turnover: How many times inventory is sold and replaced during the year (a higher number signals better efficiency).

  • Days Sales Outstanding (DSO): The average number of days customers take to pay. Longer collection periods often signal an upcoming liquidity issue.

4. Leverage Ratios: Are Debts Dragging You Down?

Debt is a double-edged sword: it can fuel growth or destroy a company.

  • Debt-to-Equity Ratio: Compares what the company owns to what it owes.

  • Interest Coverage Ratio: Indicates whether operating profits are sufficient to cover interest expenses.

5. The Arab Market Context: Sector Benchmarks

When using ratio analysis in the Arab region, sector characteristics must be considered:

  • Retail: Focus on inventory turnover and gross margin.

  • Real Estate: Emphasize leverage ratios and long-term return on investment.

  • Tech Companies: Pay close attention to cash burn rate and annual revenue growth.

6. Efficiency Levers: Automation and Dashboards

Don’t waste time calculating ratios manually every month.

  • Digital Integration: Use accounting systems that automatically extract ratios into a single dashboard.

  • Comparative Analysis: Configure systems to compare your ratios against industry peers to understand your true position.

Case Study: A Food Manufacturing Plant in Jeddah

The Challenge:
The factory records strong sales but struggles to pay suppliers on time.

Analysis via Financial Ratios:
The analysis revealed very slow inventory turnover (raw materials were piling up) and a sharp increase in DSO from 30 to 75 days.

The Result:
After reducing stagnant inventory and tightening collection policies, the quick ratio improved by 40%, freeing enough cash to pay suppliers and expand without borrowing.

Financial Ratios Checklist

  • Have you compared your ratios over the last three years to identify trends?

  • Are your liquidity ratios within safe ranges for your industry?

  • Is there a large gap between the current ratio and quick ratio (a sign of bloated inventory)?

  • Is ROE higher than your cost of financing?

  • Are DSO figures reviewed monthly to monitor sales efficiency?

  • Does your leverage ratio allow room for additional financing if needed?

  • Do your financial indicators align with your strategic objectives for the year?

Common Mistakes in Ratio Analysis

  • Relying on a single ratio: Financial ratios work as a system; don’t judge performance by profit margin alone while ignoring liquidity.

  • Ignoring accounting differences: Ensure comparisons are made with companies using the same standards, such as IFRS.

  • Overlooking non-financial factors: Ratios explain what happened, not why it happened (e.g., brand reputation changes).

Key Takeaways

  • Ratios are the language of comparison: they turn absolute numbers into meaningful indicators.

  • Balance is everything: don’t sacrifice liquidity for short-term profitability.

  • Efficiency comes before growth: improve asset turnover before seeking new capital.

  • Financial ratios are an early warning system: they reveal problems before losses become visible.

  • Sector focus matters: always benchmark against the best in your industry.

7-Point Action Plan (Analyze Your Performance Now)

  1. Select five core ratios (liquidity, profitability, efficiency) relevant to your business.

  2. Extract data from financial statements for the past two years.

  3. Calculate the ratios using the formulas above.

  4. Compare internally: is performance improving or deteriorating year over year?

  5. Compare externally: find industry benchmarks.

  6. Identify deviations: where is the real problem?

  7. Take action: set a concrete plan to improve the weakest ratio in the next quarter.

References

  • Financial Analysis: A Contemporary Approach – academic reference.

  • CFA Institute – Performance Analysis Reports.

  • Arab stock exchange data on sector performance indicators (2025).