What Is a Key Ratio?
Key ratio is the name given to any financial ratio that's considered particularly effective at measuring, illustrating, and summarizing a company's financials in relation to its competitors or peers.
Investors and companies rely on key ratios all the time to get a snapshot of liquidity, efficiency, profitability, and so forth. Each key ratio focuses on a particular aspect of the company, meaning it is often necessary to consult several of them to get a more complete idea of how the subject is faring. Those that are in sound financial health will have superior ratios to those that are performing poorly.
Key Takeaways
- Key ratios are the primary financial ratios used to illustrate and summarize the current financial condition of a company.
- They are produced by comparing different line items from the subject's financial statements.
- Analystsand investors use key ratios to see how companies stack up against their peers.
- There are plenty of financial ratios at our disposal and determining which are key varies according to opinion and the type of company being analyzed.
How a Key Ratio Works
Key ratios take data from a company's financial statements, such as its balance sheet, income statement, andstatement of cash flows, and then compare them with other items. These numbers are then 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:
Not all companies operate in the same way, so commonly used ratios tend to vary by industry. In other words, the ratios applied to best compare technology companies won't be the same as those used to effectively compare banks.
In the case of the latter, it's typical to utilize the capital to assets ratio, the loanloss reservesto total loans ratio, and the liquidity ratio. For tech stocks, on the other hand, 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 asROA and profit margin.
Advantages and Disadvantages of a Key Ratio
Key ratios represent a crucial step in determining the financial health of a company, as well as whether it is being fairly priced by investors. When utilized correctly, they can help us to pinpoint each company’s strengths and weaknesses and discover how it stacks up against its peers.
Important
Comparisons should be made with companies that are in the same industry and, ideally, have similarbusiness models.
That said, investors must be careful when using key ratios. Applying just one or two is usually not sufficient enough 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.
FAQs
Although ratio analysis can be valuable in assessing a firm's financial health, there are some limitations of ratio analysis. For instance, ratio analysis relies on past financial data and may not feel the impact of future changes in the market or a firm's operations.
Why is ratio important and the disadvantages? ›
The advantages of using ratios in analysis include providing a quick snapshot of a company's financial health. However, disadvantages include the potential for ratios to be manipulated and the need for industry-specific benchmarks.
What are the advantages of ratios? ›
Ratios make it easier to compare the execution of a process or objective with its specified criteria to determine if it is better or worse. The profitability, liquidity, and different elements of a business can be compared in this way: for accounting with itself. in collaboration with other businesses.
What is the meaning of key ratios? ›
Key ratio is the name given to any financial ratio that's considered particularly effective at measuring, illustrating, and summarizing a company's financials in relation to its competitors or peers.
What is the advantage of ratio data? ›
Advantages of Ratio Analysis are as follows:
It helps in determining how efficiently a firm or an organisation is operating. It provides significant information to users of accounting information regarding the performance of the business. It helps in comparison of two or more firms.
What are the disadvantages of current ratio? ›
One weakness of the current ratio is its difficulty of comparing the measure across industry groups. Others include the overgeneralization of the specific asset and liability balances, and the lack of trending information.
What are the disadvantages of ratio scale? ›
Disadvantages of Ratio Scale of Measurement
This means that more time and effort are required to collect data and make analysis. Limited range The rational measurement scale has a limited range because it cannot measure values less than zero.
Why ratios are good? ›
Key Takeaways. Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency. Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
Why are ratios important in real life? ›
Using ratios and proportions in everyday life includes calculating money in foreign currency while travelling abroad, determining how much of an ingredient is required to be used while following a recipe, budgeting out your monthly expenses, etc.
What is ratio and its importance? ›
Ratio analysis is vital for assessing a company's financial position, liquidity, profitability, risk, solvency, efficiency, and fund utilization. Ratio analysis provides a comparison of financial results and trends, aiding decision-making for company shareholders' investments.
The primary advantage for a company of using the current ratio is that it can help them measure their financial health. If the current ratio is less than one, it means that the firm needs to shore up its current assets to cover the immediate debt obligations or else it may face liquidity problems.
What are the advantages of activity ratio? ›
Activity ratios are useful for comparing how a company's performance is trending over time in a horizontal statement analysis or how a company's performance fares against its peers in comparable company analysis. They are also known as turnover ratios or operating efficiency ratios.
What are the 5 key ratios? ›
And that's what we'll explore here.
- Five key financial ratios for analyzing stocks.
- Price-to-earnings, or P/E, ratio.
- Price/earnings-to-growth, or PEG, ratio.
- Price-to-sales, or P/S, ratio.
- Price-to-book, or P/B, ratio.
- Debt-to-equity, or D/E, ratio.
- Finding your way.
Financial Ratios
- Financial ratios are grouped into the following categories: ...
- Current ratio = Current assets / Current liabilities. ...
- Acid-test ratio = Current assets – Inventories / Current liabilities. ...
- Cash ratio = Cash and Cash equivalents / Current Liabilities.
This relation gives us how many times one quantity is equal to the other quantity. In simple words, the ratio is the number that can be used to express one quantity as a fraction of the other ones. The two numbers in a ratio can only be compared when they have the same unit. We make use of ratios to compare two things.
What are the pros and cons of financial analysis? ›
It provides a broader perspective on financial performance, aids in setting realistic goals, and facilitates strategic decision-making. Limitations: Such analysis may be limited by differences in accounting practices, company size, and industry dynamics. Therefore, comparing such numbers becomes less straightforward.
Why is ratio analysis good? ›
Key Takeaways
Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency. Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
What are the disadvantages of the price earnings ratio? ›
The biggest limitation of the P/E ratio: It tells investors next to nothing about the company's EPS growth prospects. If the company is growing quickly, you will be comfortable buying it even it had a high P/E ratio, knowing that growth in EPS will bring the P/E back down to a lower level.
