Key Ratio Definition & Examples
Having an amazing product or service is sure to get customers buzzing. You might have the perfect solution that tackles the main problems of your target audience. But do you know how your business stacks up against the competition?
There are certain types of things that an investor or company looks into to get a look inside a company. Key ratios are an important metric that provides a snapshot into a few different areas.
So how do key ratios work and what exactly do they provide insights into? To help, we put together an in-depth guide that explains the definition of key ratio. As well, we’ll break down an example and how to get a better sense of the financial health of your business.
Keep reading to find out everything you need to know about key ratios! Before you know it, you’ll have a better sense as to your strengths and weaknesses.
Table of Contents
- Key ratios get used to summarize a company’s financial condition.
- Information from a company’s financial statements gets used to process the data. These can include income statements, statements of cash flows, and balance sheets.
- Investors and analysts benefit from using key ratios to find out how a specific company compares with another.
What Is a Key Ratio?
To put it simply, a key ratio relates to any type of financial ratio used to look into areas of your business. They’re effective at doing everything from illustrating, measuring, and summarizing. And it’s done to compare the financials of your business compared to your competition.
Many companies and investors use key ratios to dive deep into what makes a business tick. For example, they can provide an overview of things such as efficiency, liquidity, and profitability.
It’s important to understand that each key ratio is going to focus on a specific element of a company. This means that to get a complete snapshot, it’s necessary to look into multiple key ratios.
When a company is in good financial health, its key ratios are typically going to be much higher. And a company that isn’t performing particularly well will likely have lower ratios.
How Does a Key Ratio Work?
Every company is going to have certain kinds of financial statements. These can include things like a statement of cash flows, a balance sheet, and an income statement. A key ratio retrieves the data from these statements and then compares them with others.
Then, the numbers get calculated to come up with a ratio that’s going to relate to certain areas of a company’s health. For example, an investor might want to get a better sense of profitability or liquidity. Key ratios are also good to learn more about the use of debt or potential earnings strength.
What Are the Primary Key Ratios?
Depending on what you’re looking for, there are any number of financial ratios you could look into. That said, there is a handful that get used more often than others. These include:
- Return on assets ratio
- Working capital ratio
- Price-earnings ratio
- Return on equity ratio
- Return on investment ratio
- Liquidity ratios
- Debt to equity ratio
- Debt to asset ratio
Key Ratio Example
Let’s say that an investor wants to learn more about your company. They’d start by getting access to your most recent financial statement. Here, they can gain insights from your balance sheet assets, income statement, and accounting practices.
Then, the investor can dive deeper, finding out how your company generates profits and how you manage your expenses. They can use key profitability ratios like profit margin and return on assets. All of this information would come from looking at things like accounts payable, net income, sales, and operating expenses.
The investor can gain insights from other areas such as net assets figures and the operating costs of your company. Plus, they’ll have a better sense of things like current liabilities, cash flow, and stock price if you have one.
A key ratio gets used to observe the financial condition of a particular company. They’re primary financial ratios that get produced by comparing line items from financial statements. Basically, it’s an analysis of financial statements and it can be used by several business models.
It’s an effective way for an investor or analyst to get a better sense of how one business compares with another. They’re a fundamental analysis used to determine the overall financial health of a company. Plus, a key ratio gives a complete picture of core business operations, such as operational efficiency.
When a key ratio is used properly it can give an overview of the biggest strengths and weaknesses. That said, one key ratio typically isn’t enough to provide a deep enough snapshot. Putting together multiple key ratios is the most effective way to get a true overview of a company’s financial performance.
Frequently Asked Questions
What Are the Key Ratios in Forecasting?
It might depend on the type of business you operate and accounting methods, but there can be some common key ratios used for forecasting. These can include profitability, activity, debt, liquidity, and market.
Which Ratio is Best for Profitability?
One of the most widely used margins or profitability ratios is the gross profit margin. This is the difference between your revenue and the total costs of production. Costs of production are also referred to as the cost of goods sold (COGS). It can be a good metric for companies to use.
Why Does a Key Ratio Matter?
Key ratios provide you with actionable insights into the financial health of your business. When you use key ratios effectively, they can help highlight your strengths and weaknesses. Key ratio analysis gives a better sense of your company performance.
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