The company with the highest sales or even the highest profit is not necessarily the most successful in its field.

For instance, a company with strong sales growth might still be going broke while one with high profits might be damaging its long-term viability by failing to invest or selling poor quality goods.

It is essential, therefore, not to examine a single measure of financial performance in isolation.

What ratios do allow, however, when taken together, is an insight into overall performance that helps to provide an explanation for success or failure relative to the objectives of the business.

High and low results are not absolute and can only be effectively judged in the short term against other companies within the same industry.

For example, a printer earning a pre-tax profit margin of 4% is faring relatively well overall, but, is under-performing relative to other printing and publishing businesses.

On the other hand, there is a view that all businesses compete for scarce resources in common financial and labour markets and therefore comparisons with all other companies are warranted.

A first glance at a set of financial accounts normally involves examining trends in profitability.

The pre-tax profit margin is simply a measure of the profit earned per pound of sales, a quick indicator of the value a business is adding to the resources it uses.

It is akin to a shopkeeper's 'mark up' and is very easy and quick to calculate. Although a higher margin is better than a lower one, it is worth noting that a high margin works in both directions since a given drop in sales will have a greater impact on profits than for a business with a lower margin.

In other words, a business with a high margin will tend to do better than most when sales are rising and worse than most when sales are falling.

Return on capital is a useful measure of overall corporate profitability.

It is a key measure of managerial performance as it relates the resources employed in the business to the pre-tax profits generated from those resources.

In other words it is the financial reward that the business yields in return for the money invested that otherwise could have been invested elsewhere. It is defined as pre-tax profit divided by capital employed.

The state of the working capital cycle has important implications for businesses, notably the amount of pressure that is put on cash flow.

Working capital is a measure of the extent to which funds are tied up in terms of stock and the trade account (payments to suppliers etc and receipts from customers etc) in generating every £1 worth of sales.

The concept of cash flow is crucial, in that most businesses fail because they run out of cash rather than that they are not profitable. The old adage that ‘cash is king’ and ‘profit is a matter of opinion’ is still true.

For most businesses, the largest single cost is wages. Therefore, how the wages to sales ratio moves over time indicates how effectively labour costs have been controlled and how efficiently labour is being used.

This ratio, which highlights how much sales are generated for every £100 spent on wages, varies greatly between firms (depending on labour productivity or efficiency) and industries (depending on labour intensity).

In terms of indebtedness, it is common to express total debts taken out by a business in relation to equity, ie. shareholders funds invested in that business.

Technically, this is referred to as ‘gearing’. A business that is heavily indebted (or highly geared), with say debt to equity of over 150%, may experience problems associated with being under-capitalised and is more vulnerable to changes in the business cycle (interest rates).

It is not uncommon for a mature industry, such as textiles manufacturing, to have relatively low debts in relation to equity because there is little on-going investment taking place.

In contrast, businesses based on property, such as hotels or pubs, are often relatively highly indebted in relation to equity but may not be in terms of total assets.

From the perspective of a company's bank manager, the most important feature is the overall ability to repay outstanding loans rather than profitability or indebtedness.

To this end, gross interest cover expresses:

• profits before interest payments and taxation (PBIT) against
• interest payments

in an attempt to measure more closely 'an ability to pay'.

A low interest cover, therefore, suggests that a sector is more vulnerable to changes in the business cycle.