Key ratio is essential for any financial metric considered particularly effective at measuring, illustrating, and summarizing a company’s financial performance compared to its competitors or peers.
Investors and companies frequently rely on key ratios to get a snapshot of liquidity, efficiency, profitability, and other key financial aspects. Each key ratio focuses on a specific part of the company’s finances, which means it’s often necessary to consult several of them to get a comprehensive idea of a company’s health. Companies in good financial health typically have superior ratios compared to those performing poorly.
Key Takeaways
- Key ratios are essential financial ratios used to illustrate and summarize a company’s current financial condition.
- They are produced by comparing different line items from the company’s financial statements.
- Analysts and investors use key ratios to see how companies stack up against their peers.
- There are numerous financial ratios at one’s disposal, and determining which are key varies according to opinion and the type of company being analyzed.
How a Key Ratio Works
Key ratios use data from a company’s financial statements, such as its balance sheet, income statement, and statement of cash flows, to compare them with other items. These numbers are calculated together to produce a ratio that represents key aspects of the company’s financial picture, such as liquidity, profitability, use of debt, and earnings strength.
There are plenty of financial ratios at one’s disposal, and determining which are key varies according to opinion and popularity. Some of the most prevalent ratios include:
- Working Capital Ratio: Current assets are divided by current liabilities to establish how capable a company is of meeting its current financial obligations.
- Price-Earnings (P/E) Ratio: Divide the current stock price by earnings per share (EPS) to determine the price investors pay for $1 of a company’s profit.
- Return on Assets (ROA): Divide net income by total assets to discover the percentage of profit a company earns in relation to its resources.
- Return on Equity (ROE): Divide net income by shareholders’ equity to see how efficiently investor’s capital is being put to use by the company’s management.
Not all companies operate the same way, so commonly used ratios tend to vary by industry. The ratios applied to compare technology companies effectively won’t be the same as those used to compare banks.
For banks, it’s common to utilize the capital to assets ratio, the loan loss reserves to total loans ratio, and the liquidity ratio. For tech stocks, analysts and investors usually prefer to examine price-to-sales (P/S) ratios, return on research capital (RORC), and so forth.
Example of a Key Ratio
Sam is an analyst with XYZ Research and wants to learn more about ABC Corp. He goes to ABC Corp’s investor relations website and downloads its most recent financial statements.
Sam wants to find out how efficient ABC Corp is at managing its expenses to generate profits. Looking at net income, sales, operating costs, accounts payable, and net assets figures, Sam computes some of ABC Corp’s key profitability ratios, such as ROA and profit margin.
Advantages and Disadvantages of Key Ratios
Key ratios represent a crucial step in determining the financial health of a company and whether it is being fairly priced by investors. When utilized correctly, they can help pinpoint a company’s strengths and weaknesses and discover how it compares against its peers.
Important
Comparisons should be made with companies that are in the same industry and, ideally, have similar business models.
However, investors must be careful when using key ratios. Applying just one or two is usually not sufficient to get the full picture. A company can seldom be properly evaluated or analyzed using just one ratio in isolation.
Moreover, it’s worth bearing in mind that companies may adhere to different accounting practices, making them harder to compare. A combination of ratios should be used in conjunction with one another after determining which are the most appropriate for a given case.
Related Terms: liquidity ratios, profitability ratios, operating costs, balance sheet, income statement
