Ratio analysis is the quantitative approach to finding the company’s actual financial position, including revenue, expense, profitability, liquidity, etc. It’s essential to understand the top financial ratios and their implications to be a successful investor and manager.
Highlighting the importance of financial ratios, Warren Buffet once mentioned that, ‘Ratio analysis is the language of business. It provides the means to interpret and understand a company’s financial performance and position.
But, using all available ratios for financial interpretation might be challenging. I have listed the top five critical financial ratios to succeed in investing and professional life.
1. Return on Investment (ROI):
Formula: (Net Profit / Total Investment) * 100
Importance:
ROI measures the efficiency of an investment by comparing the return generated to the initial investment. It helps investors assess the profitability of their investments.
Drawbacks:
ROI does not consider the time value of money or the duration of the investment. It also doesn’t account for the risk associated with the investment.
2. Return on Assets (ROA):
Formula: Net Income / Total Assets
Importance:
ROA indicates how efficiently a company is using its assets to generate profits. It helps assess management’s effectiveness in utilizing resources.
Drawbacks:
Industry norms and asset valuation methods can influence ROA. It may only provide a comprehensive view of profitability if assets are utilized optimally.
3. Return on Equity (ROE):
Formula: Net Income / Shareholders’ Equity
Importance:
ROE measures the return generated on shareholders’ equity investment. It helps evaluate the profitability and efficiency of equity utilization.
Drawbacks:
ROE can be inflated by financial leverage (debt). A high ROE may not necessarily indicate good financial performance is achieved through excessive borrowing.
4. Current Ratio:
Formula: Current Assets / Current Liabilities
Importance:
The current ratio assesses a company’s short-term liquidity and ability to cover immediate obligations with current assets. It indicates whether a company has sufficient resources to meet short-term liabilities.
Drawbacks:
A high current ratio may indicate inefficiency in asset utilization, while a low ratio may signal liquidity problems. It does not consider the quality of assets or the timing of cash flows.
5. Quick Ratio (Acid-Test Ratio):
Formula: (Current Assets – Inventory) / Current Liabilities
Importance:
The quick ratio provides a more conservative measure of liquidity by excluding inventory, which may not be easily convertible into cash. It assesses a company’s ability to meet short-term obligations using its most liquid assets.
Drawbacks:
Excluding inventory from the calculation may not accurately reflect a company’s liquidity position if inventory turnover is rapid. It does not consider future cash inflows or outflows.
