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14 | The Lion King
Understanding and using
Key Financial Ratios
By Michael Nwanolue
S
ome investors may rather
leave their investment deci-
sions to fate than try to utilize
“seemingly daunting” financial
ratios, as they often appear to
be. The truth is that ratios should
not be intimidating. In fact, you
do not need a degree in a nu-
meric or finance-related disci-
pline to do them. Using ratios to
make informed decisions about
an investment is invaluable, once
you know how to use them.
What are financial ratios?
They are tools used in evaluat-
ing the quality of a company.
More often than not, they are
calculated by taking one finan-
cial data or figure in relation to
another. These financial data are
obtained from a company’s fi-
nancial statements, the financial
markets or an economic data
board.
Suffice it to say that financial
ratios do not make much sense
when considered in isolation;
their values are more meaning-
ful when compared with those
of other companies or periods.
Comparison can be vertical -
evaluating the ratios for the same
company over different periods,
or horizontal – evaluating ratios
of similar companies (in terms of
size or industry).
Types of financial ratios
Most financial ratios fall into
one of the following four classes
below.
1. Profitability Ratios
2. Liquidity Ratios
3. Solvency Ratios
4. Valuation Ratios
PROFITABILITY RATIOS
These set of ratios depict
how efficient an organiza-
tion operates. Profit is the key
yardstick here, and investors are
interested in the rate of profit.
While growth in revenue is a
necessary condition for perform-
ance, the sufficient condition is
growing the rate of profit, which
will ultimately translate into
better returns (and dividends) for
investors.
a. Return on Equity (RoE):
This
is the most important profit-
ability ratio for investors. It is a
measure of efficiency in the
use of shareholders’ funds. It
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