Master These Financial Ratios Before You Buy a Share

From profitability to debt, financial ratios reveal the real story behind a company’s numbers and help investors make better decisions

Open any company’s financial report, and you are met with a jungle of numbers. Revenues, expenses, profits, liabilities—it is all there, but what do these numbers actually tell us? For most of us, reading them line by line is exhausting.

That is where financial ratios come in. Ratios are like signposts. They don’t overwhelm you with data but instead give you quick answers to essential questions:

• Can the company pay its short-term bills?

• Is it really making money, or just showing off big revenues?

• Is it piling on too much debt?

• Is the stock reasonably priced, or overhyped?

In short, ratios turn raw numbers into a story about how healthy—or unhealthy—a business really is.

What Exactly Are Financial Ratios?

At their core, financial ratios are just comparisons. One number divided by another. But that simple math can reveal a lot.

Take this example: a company makes a profit of ₹10 crore on sales of ₹100 crore. That works out to a profit margin of 10%. With just one ratio, you already know how much the business keeps after covering costs.

Ratios don’t add anything new—they reorganise information to make it easier to understand.

The Main Types of Ratios

There are many ratios, but most fall into five broad groups. Here is a plain breakdown:

1. Liquidity Ratios

Tell you whether a company can cover its short-term obligations.

• Current Ratio = Current Assets ÷ Current Liabilities
  If a company has ₹200 crore in current assets and ₹100 crore in current liabilities, the current ratio is 2.

Good: Around 1.5–2.0 shows the company can pay its bills without tying up too much idle cash.
Bad: Below 1 means the company might struggle to meet short-term obligations; too high (say 4+) may indicate poor use of resources.

2. Profitability Ratios

Show how effectively a company earns profits from sales.

• Net Profit Margin = Net Profit ÷ Sales

• Return on Equity (ROE) = Net Profit ÷ Shareholders’ Equity

Good: Higher margins or ROE than industry peers signal efficiency and pricing power.
Bad: Consistently low margins or falling ROE can mean rising costs, weak demand, or poor management.

3. Leverage Ratios

Indicate how much a business relies on borrowed money.

• Debt-to-Equity Ratio = Total Debt ÷ Equity

Good: A ratio below 1 is generally healthy—it shows the company is not overdependent on debt.
Bad: A ratio above 2 suggests high debt, which becomes risky in times of rising interest rates or slowing revenue.

4. Efficiency Ratios

Measure how well resources are being used.

• Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Good: Higher turnover means products are selling quickly, reducing storage costs and risk of obsolescence.
Bad: Very low turnover means unsold stock is piling up—possibly weak demand or poor inventory management.

5. Market Ratios

Reflect investor perception of the company.

• Price-to-Earnings (P/E) Ratio = Market Price per Share ÷ Earnings per Share

Good: A moderate P/E compared to peers can show fair value.
Bad: Very high P/E may mean the stock is overpriced; very low P/E could signal undervaluation—or deeper problems in the business.

Why They Matter

Looking at raw figures doesn’t tell you much. A business could show ₹1,000 crore in revenue but end up with only a tiny profit. Ratios cut through the noise:

• Investors use them to decide whether a stock is undervalued or overpriced.

• Managers track them to spot areas where performance can improve.

• Banks and lenders rely on them to gauge repayment ability.

• Analysts use them to compare companies in the same industry.

Ratios simplify complexity—they help you see the bigger picture without drowning in numbers.

A Practical Example

Suppose a company has a Debt-to-Equity Ratio of 0.8. That means for every ₹1 of equity, it carries 80 paise of debt. For a giant corporation with stable cash flows and diversified operations, this may be a fairly balanced financial structure. But for a medium-sized firm, the same ratio could bring moderate pressure, especially if revenues fluctuate. For a small business, even this level of debt can become risky, since earnings are often less predictable and a sudden slowdown in demand or rise in costs could strain repayment capacity.

Now look at profitability. If a business shows a Net Profit Margin of 18%, it means that for every ₹100 in sales, ₹18 remains as profit. Compared to another company in the same sector with a margin of just 7%, the difference highlights how much more efficiently one business is operating than the other.

This is why ratios must always be viewed in context—not only across industries but also across company sizes. Numbers alone don’t tell the full story, but ratios give investors quick insights that can save hours of digging through reports.

What Ratios Can’t Tell You

It is important to keep perspective. Ratios have limits:

• A “good” ratio in one industry might be poor in another.

• A single year’s numbers may not show the full trend.

• They don’t capture intangibles like brand strength or leadership quality.

Think of them as health indicators. Just as a doctor checks blood pressure, cholesterol, and heart rate together, investors should view multiple ratios to get the full picture.

Final Word

Financial ratios would not guarantee profits, but they can stop you from making blind decisions. They are simple tools that expose the reality behind headlines like “record sales” or “biggest profit ever.”

The next time you hear about a company’s growth story, don’t just take the numbers at face value. Look at the ratios. That’s where you will find whether the story truly holds up.