There are 4 common types of financial ratios that a good financial analyst will use to assess the performance of a business or project in building or interpretating the results of a financial model.
These 4 performance ratios are by no means exhaustive, but provide a good rule of thumb indication on the most important ones to take note of in a financial modeling exercise.
- Return on assets (ROA), this ratio provides an indication of how effectively a business is utilizing its investments in assets : ROA = Net income / Average assets
- Operating margin, a good high-level indicator of profitability and profit potential or “wiggle room” (robustness to competitive and external factors that may reduce profitability in the short-run) : Operating margin = EBIT / Sales
- Asset turnover, this ratio provides a further indication of the effectiveness of capital/asset utilization and relative “capital intensity” of a business: Asset turnover = Sales / Average assets
- Return on Equity (ROE), also known as the Return on average common equity or return on net worth, measures the rate of return on the ownership interest (shareholders’ equity) of the common stock owners. ROE measures a firm’s efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth. Look at the illustration below for details of the formula for ROE:
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