Accounting – 5 Most Important Financial Ratios

• The current ratio. The current ratio estimates your company’s ability to pay its short-term obligations.
• Debt-to-Equity ratio.
• The acid test ratio.
• Net profit margin.
• Return on Equity.

A company enjoying good financial health should obtain a ratio around 2 to 1. An exceptionally low solvency ratio indicates that the company will find difficulties in paying its short-term debts.

20%

A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more. A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group.

A rising ROE suggests that a company is increasing its profit generation without needing as much capital. It also indicates how well a company’s management deploys shareholder capital. A higher ROE is usually better while a falling ROE may indicate a less efficient usage of equity capital.

The higher the ROE, the better. But a higher ROE does not necessarily mean better financial performance of the company. As shown above, in the DuPont formula, the higher ROE can be the result of high financial leverage, but too high financial leverage is dangerous for a company’s solvency.

High ROE: Whilst UPS’s Return on Equity (72.22%) is outstanding, this metric is skewed due to their high level of debt.

Return on equity (ROE) is measured as net income divided by shareholders’ equity. When a company incurs a loss, hence no net income, return on equity is negative. If net income is consistently negative due to no good reasons, then that is a cause for concern.

The way that a company’s debt is taken into account is the main difference between ROE and ROA. In the absence of debt, shareholder equity and the company’s total assets will be equal. But if that company takes on financial leverage, its ROE would be higher than its ROA.

Sometimes ROE figures are compared at different points in time. Declining ROE suggests the company is becoming less efficient at creating profits and increasing shareholder value. To calculate the ROE, divide a company’s net income by its shareholder equity.

A company can improve its return on equity in a number of ways, but here are the five most common.

1. Use more financial leverage. Companies can finance themselves with debt and equity capital.
2. Increase profit margins.
3. Improve asset turnover.
4. Distribute idle cash.
5. Lower taxes.
6. 1 great stock to buy for 2015 and beyond.

ROE is a measure of financial performance which is calculated by dividing the net income to total equity while ROA is a type of return on investment ratio which indicates the profitability in comparison to the total assets and determines how well a company is performing; it is calculated by dividing the net profit with …

Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or capital.

ROA (Return On Assets) calculates how much income is generated as a proportion of assets while ROI (Return On Investment) measures the income generation as opposed to investment.

– ROI is calculated by taking your net gain or loss and divides it by the total amount you have invested. It is total profit divided by your initial investment. ROE, on the other hand, measures how much profit a company generates when compared to its shareholders’ equity.