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 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.
- Analysts and 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, and statement 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:
- 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 the resources it has at its disposal.
- 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 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 loan loss reserves to 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 as ROA 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.
Comparisons should be made with companies that are in the same industry and, ideally, have similar business 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.