What is a key ratio?
Any financial ratio considered especially useful for assessing, presenting, and summarizing a company’s financials compared to its peers or competitors is referred to as a critical ratio. Businesses and investors frequently use key ratios to get a general overview of liquidity, efficiency, profitability, and other factors. Since each critical ratio focuses on a different business component, it is frequently essential to reference multiple of them to have a more comprehensive understanding of the subject’s performance. Superior ratios distinguish people in good financial standing from those who are not.
Functions of a Key Ratio
Key ratios compare data with other items by taking information from a company’s financial statements, including the balance sheet, income statement, and statement of cash flows. The ratio that results from adding these figures together illustrates essential elements of the business’s financial picture, including debt utilization, liquidity, profitability, and earnings strength.
One can choose from a wide range of financial ratios, and popular opinion and opinion polls often influence the most important ones. Among the most widely used ratios are the following:
- Working capital ratio: The division of current assets by liabilities reveals a company’s capacity to meet its immediate financial obligations.
- Price-Earnings (P/E) Ratio: To determine how much investors are willing to pay for $1 of a company’s profit, divide the current stock price by earnings per share (EPS).
- Return on assets (ROA) is the percentage of profit a business makes from the resources at its disposal. It is calculated by dividing net income by total assets.
- Return on equity (ROE) measures how well the company’s management uses investor capital by dividing net income by shareholders’ equity.
Since no two businesses are the same, industry-specific, commonly utilized ratios tend to differ. Put differently, the ratios used to assess technology businesses will not be the same as those used to compare banks.
For the latter, it is customary to employ the ratios of capital to assets, loan loss reserves to total loans, and liquidity. However, regarding tech stocks, analysts and investors typically like to look at metrics like price-to-sales (P/S) ratios, return on research capital (RORC), and other similar measures.
Key Ratio Illustration
Sam, an analyst with XYZ Research, is curious to learn more about ABC Corp. He downloads the most recent financial statements from ABC Corp.’s investor relations website.
Sam is interested in learning how effectively ABC Corp. controls its costs to turn a profit. Sam calculates some of the essential profitability statistics for ABC Corp., like ROA and profit margin, by looking at data on net income, sales, operating costs, accounts payable, and net assets.
Benefits and Drawbacks
An essential step in assessing a company’s financial health and whether investors are pricing it correctly is to look at critical ratios. When used effectively, they can assist us in identifying the advantages and disadvantages of each business and how it compares to its competitors.
However, when utilizing important ratios, investors need to exercise caution. Usually, one or two won’t be enough to obtain the whole picture. Seldom can a corporation be adequately assessed or examined by relying solely on one ratio in isolation.
It’s also crucial to keep in mind that various organizations may adhere to various accounting standards, which makes comparisons more challenging. Once the most suitable ratios for a particular situation have been identified, a mixture of ratios should be applied together.
Conclusion
- People use vital statistics to show and describe a company’s financial situation.
- Their creation involves looking at various line items from the subject’s financial records and finding similarities.
- Many buyers and analysts use key statistics to compare a company to its peers.
- There are many financial factors to choose from, and which ones are most important depends on the person and the type of business being looked at.