Sometimes you need a comparison. A benchmark. Are you better then yesterday? Are you better than your competitor?
Financial ratios are used to discern relative magnitude of values from your financial statements. That means that you take for example net profit and divide it with sales. That is coincidentally your profit margin and one of many profitability ratios.
The reason for comparing ratios and not absolute values is twofold: - Company with revenue of 1 mil and profit 300 thousands is not in any sense less successful than company with revenue 2 mil and profit 400 thousand. The first one works smarter for their money, if anything. - That implies similar products or services. But you can compare companies to choose which sector or approach will be profitable for you.
We recognise 2 main families of financial ratios. Profitability ratios based largely on profits and efficiency ratios based mainly on assets. There of course few more.
Profitability ratios
For example one of the profitability ratios is return on asset. It shows how profitably is company using all of their assets, in a ratio based on net profit divided by total assets (often averaged over whole year). The higher the better.
Return on Equity is another important one. It is calculated in similar manner and shows how much does a one dollar invested into equity return over a year.
If you are using profitability ratios, you should take care of what exactly are you comparing. If you want to compare different companies, you should use an EBIT instead of net profit, because it takes out interest and taxes out of the equation, which depends on the capital structure.
On the other hand, if you compare companies with similar structure net profit is a useful variable.
Efficiency ratios
Efficiency ratios deal very often with turnover of assets or liabilities. What you are trying to calculate with them is for example how many times do you need to restock your inventory to sell your yearly amount. The basic calculation is Cost of Goods Sold/average inventory.
You can also turn the calculation around and see how long does your one average product stays in stock before being shipped. 365/inventory turnover. You can calculate the same for Accounts receivable (compare to sales) and accounts payable (compare to cogs and other expenses)
Your final calculation can then be (Inventory Conversion Period) + (Receivables Conversion Period) - (Payables Conversion Period) - the cash conversion cycle. You can see how long does it take from the moment you pay for your inventory to the time you get paid.
All by themselves are financial ratios not that informative. However in time series or in comparison with other companies especially in the same sector, you can spot your weaknesses. And opportunities for growth.