Key Ratio
Candlefocus EditorThe most widely used key ratios include profitability, liquidity, solvency, and efficiency ratios.
Profitability ratios measure a company’s ability to generate profits and create value for shareholders. Ratios such as gross margin, operating margin, return on assets (ROA), and return on equity (ROE) are all important indicators of a company’s financial health. A company with a high return on assets and/or return on equity can provide shareholders with higher returns than its peers.
Liquidity ratios measure a company’s ability to pay its short-term debts. The most commonly used liquidity ratio is the current ratio, which measures the company’s current assets relative to its current liabilities. A company with a higher current ratio is considered more liquid than one with a lower ratio.
Solvency ratios measure a company’s long-term debt-paying ability. The most commonly used ratio is the debt-to-equity ratio (also known as the leverage ratio), which compares a company’s total liabilities to its total shareholders’ equity. A high debt-to-equity ratio is usually a warning sign that the company may be incurring too much debt, making it vulnerable to financial distress.
Finally, efficiency ratios measure how well a company is using the resources at its disposal. The most common efficiency ratios are inventory turnover, accounts receivable turnover, and asset turnover. A company with greater asset turnover is typically more efficient than one with a lower ratio.
Key financial ratios are an essential tool for evaluating a company’s performance and make up a key part of the financial analysis process. Knowing which ratios are important and understanding how to interpret them is essential for anyone looking to make smart investment decisions. Analyzing key ratios can help investors identify companies with strong financial positions and avoid taking unnecessary risks with their investments.