Key ratio - What is a key ratio?
A key ratio refers to ratios that hold a particular importance to a business when it comes to determining its performance in relation to the competition
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It’s important for businesses to maintain a general understanding of their performance, both as compared to previous periods but also compared to other businesses in the same industry.
Ratios are a common measurement used to gauge how well a business is doing financially. Key ratios refer to the ratios that are pertinent to understanding financial performance of a business. Different businesses might use different key ratios depending on the industry and what is essential for keeping track of their standing in the market.
Common key ratios
While there are a variety of ratios that a business might choose to use to measure their financial health, there are some that are quite common as they provide insight into the basics of a business’ performance:
Ratio of net income to assets (ROA)
The return on assets ratio or ROA is a profitability ratio that allows a business to examine how well a business is handling its assets. A low ROA means that improvements can be made as far as how assets are managed, while a high ROA means that the business is managing them effectively.
However, because this ratio deals with assets, depreciation and unexpected additional expenses might impact the outcome.
Ratio of net income to total investments (ROI)
The ROI is a common profitability ratio that measures how well a business is managing an investment. In other words, how profitable that investment is based on the gain or loss expected or experienced.
ROI is a popular ratio for businesses as it allows them to easily generate a better understanding of how the gains from an investment will compare to the costs of the investment.
The current ratio is a liquidity ratio that allows a business to determine how well they will be able to pay their upcoming short-term (current) expenses. For most businesses, ‘current’ refers to roughly within the next year.
A low current ratio means that the company might not be able to pay off their upcoming expenses. A high current ratio means that the company will be able to comfortably pay their coming expenses and might have additional cash that can be invested in other parts of the business.
The debt ratio is a leverage ratio, which means that it is used to help a business look at how much they have borrowed in order to operate. This ratio allows businesses to keep track of how much of their capital is sourced through borrowing, causing debt.
If a business has a debt ratio above 1.0, this means that they are likely insolvent and have a negative net worth.
These are only a small selection of a large variety of different ratios that businesses can use to help measure profitability, liquidity, leverage, and efficiency. The ratio used depends on what the business is looking to measure as well as the industry, size of the business, and more.
Who uses key ratios
The ratios that a businesses selects and uses as their key ratios will provide insights not only into the finances and the business, but also potentially into how well the business is being managed. Management will take key ratios into account, using the information as a quick way to determine whether changes need to be made in certain areas to improve performance.
Stakeholders and potential investors will also often look at key ratios of a business in order to determine whether to buy into a business or sell stock, for example. Basically, key ratios provide valuable insights into how well a business is handling its finances, in the past, present, and future.