What is a Key Ratio?
A key ratio is any financial ratio that is especially important, prevalent, or necessary in analyzing a company's performance in relation to other companies, the industry or the market.
How Does a Key Ratio Work?
Key ratios calculate various pieces of financial data in relation to one another. There are dozens of financial ratios out there, and what is 'key' is usually a matter of opinion and tradition. In fact, there are too many important ratios to list here in this definition. Some examples of key ratios might be the price-to-sales ratio (Price-to-Sales Ratio = Market Capitalization/Annual Sales) or the P/E ratio, which is price per share/earnings per share. Other key ratios include return on assets, return on equity, or price to book value.
The idea is that managers can rely on key ratios for instant snapshots and analysis of the condition of the business. Analysts use these same sets of ratios to compare companies.
Why Does a Key Ratio Matter?
Investors often use quantitative and technical analyses, including key ratios, stock chart analysis and other mathematical measures to determine whether to buy or sell.
Regardless of the investment method, however, ratio analysis is crucial to understanding an investment. After all, it is through these key ratios that we detect whether a company is encountering difficulties paying the bills, taking too long to collect money from customers, unable to pay its debts, whether its stock is overpriced, and a wide variety of other insights. The mathematics typically only involve simple division, but the insights they yield can be invaluable.
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