Financial ratios are key tools for evaluating a company’s financial health and performance. They allow investors, analysts, and business owners to better understand how a company is performing, both over time and compared to its peers.
In this guide, we will explain the different types of financial ratios, why they matter, and provide clear examples to help you get started with financial ratio analysis.
What Are Financial Ratios?
Financial ratios are mathematical calculations derived from a company’s financial statements, such as the balance sheet, income statement, and cash flow statement.
These ratios offer insights into a company’s profitability, liquidity, efficiency, and valuation, helping investors and analysts assess its financial performance.
Key Categories of Financial Ratios:
- Profitability Ratios – Measure a company’s ability to generate profit relative to its revenue, assets, and equity.
- Leverage Ratios – Evaluate a company’s use of debt and its ability to meet financial obligations.
- Valuation Ratios – Help determine if a company’s stock is fairly priced based on its earnings and assets.
Why Are Financial Ratios Important?
Financial ratios play a crucial role in financial analysis. They help:
- Assess Company Performance: Track performance over time and compare it with competitors.
- Make Investment Decisions: Aid investors in deciding whether to buy, sell, or hold stocks.
- Evaluate Risk: Measure financial risk, especially in companies with high levels of debt.
By analyzing these ratios, you can better understand a company’s financial health and make informed decisions.
Key Profitability Ratios
Profitability ratios assess a company’s ability to generate profits from its revenue, assets, and equity. Some of the key profitability ratios include:
EBITDA Margin
The EBITDA margin shows how much of a company’s revenue turns into operating profit, before interest, taxes, and depreciation.
Formula: EBITDA Margin = (EBITDA / Total Revenue) × 100
Example: If a company has an EBITDA of ₹200 crores and total revenue of ₹1,000 crores, the EBITDA margin is: EBITDA Margin = (200 / 1000) × 100 = 20%
PAT Margin (Profit After Tax)
This ratio measures the overall profitability after accounting for all expenses, including taxes.
Formula: PAT Margin = (PAT / Total Revenue) × 100
Example: If PAT is ₹100 crores and revenue is ₹1,000 crores: PAT Margin = (100 / 1000) × 100 = 10%
Return on Equity (ROE)
ROE measures how effectively a company uses shareholders’ equity to generate profit.
Formula: ROE = (Net Profit / Shareholder’s Equity) × 100
Example: If a company has a net profit of ₹50 crores and shareholder’s equity of ₹400 crores: ROE = (50 / 400) × 100 = 12.5%
Understanding Leverage Ratios
Leverage ratios assess how much debt a company has in relation to its equity and assets, indicating its financial risk.
Interest Coverage Ratio
This ratio shows a company’s ability to cover its interest expenses from earnings.
Formula: Interest Coverage Ratio = EBIT / Interest Expense
Example: If EBIT is ₹120 crores and interest expense is ₹30 crores: Interest Coverage Ratio = 120 / 30 = 4.0
Debt to Equity Ratio
This ratio compares a company’s total debt to its shareholder’s equity. A ratio above 1 indicates higher reliance on debt financing.
Formula: Debt to Equity Ratio = Total Debt / Total Equity
Example: If total debt is ₹200 crores and total equity is ₹100 crores: Debt to Equity Ratio = 200 / 100 = 2.0
Debt to Asset Ratio
This ratio shows what percentage of a company’s assets are financed by debt.
Formula: Debt to Asset Ratio = Total Debt / Total Assets
Example: If total debt is ₹150 crores and total assets are ₹300 crores: Debt to Asset Ratio = 150 / 300 = 0.5
Valuation Ratios
Valuation ratios help investors determine if a company’s stock is overvalued or undervalued relative to its financial performance.
Price to Sales (P/S) Ratio
This ratio compares the company’s stock price to its sales, showing how much investors are willing to pay for each dollar of sales.
Formula: P/S Ratio = Current Share Price / Sales per Share
Example: If the stock price is ₹50 and sales per share are ₹10: P/S Ratio = 50 / 10 = 5.0
Price to Book Value (P/BV) Ratio
The P/BV ratio compares the company’s stock price to its book value (net assets).
Formula: P/BV Ratio = Current Share Price / Book Value per Share
Example: If the stock price is ₹80 and book value per share is ₹40: P/BV Ratio = 80 / 40 = 2.0
Price to Earnings (P/E) Ratio
This ratio shows how much investors are willing to pay for each dollar of earnings.
Formula: P/E Ratio = Current Share Price / Earnings per Share (EPS)
Example: If the stock price is ₹120 and EPS is ₹10. P/E Ratio = 120 / 10 = 12.0
Liquidity Ratios
Liquidity ratios assess a company’s ability to cover short-term liabilities with its most liquid assets.
Current Ratio
The current ratio measures a company’s ability to cover its current liabilities with current assets.
Formula: Current Ratio = Current Assets / Current Liabilities
Example: If current assets are ₹500 crores and current liabilities are ₹300 crores: Current Ratio = 500 / 300 = 1.67
Quick Ratio
The quick ratio excludes inventory, providing a more stringent measure of liquidity.
Formula: Quick Ratio = (Cash + Receivables + Short-Term Investments) / Current Liabilities
Example: If quick assets are ₹200 crores and current liabilities are ₹300 crores: Quick Ratio = 200 / 300 = 0.67
Cash Ratio
The cash ratio is the most conservative liquidity measure, focusing solely on cash and cash equivalents.
Formula: Cash Ratio = Cash + Cash Equivalents / Current Liabilities
Example: If cash is ₹100 crores and current liabilities are ₹300 crores:
Cash Ratio = 100 / 300 = 0.33
Activity Ratios
Activity ratios evaluate how efficiently a company uses its assets to generate sales.
Inventory Turnover Ratio
This ratio measures how often a company sells and replaces its inventory.
Formula: Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
Example: If COGS is ₹600 crores and average inventory is ₹200 crores:
Inventory Turnover = 600 / 200 = 3.0
Receivables Turnover Ratio
This ratio shows how efficiently a company collects receivables.
Formula: Receivables Turnover = Net Sales / Average Receivables
Example: If net sales are ₹800 crores and average receivables are ₹100 crores: Receivables Turnover = 800 / 100 = 8.0
Financial ratios are essential for understanding a company’s financial health. By analyzing profitability, leverage, liquidity, valuation, and efficiency ratios, investors and analysts can gain deeper insights into a company’s operations and financial stability.
To make the most of financial ratio analysis, compare these ratios over time and against industry peers. With these tools, you’ll be better equipped to make informed investment decisions and evaluate a company’s performance in the market.
Key takeaways
- Financial ratios, including profitability, leverage, and liquidity ratios, are essential tools for assessing a company’s financial health and performance.
- Comparing financial ratios over time and against industry competitors helps identify trends, measure growth, and evaluate how a company performs relative to others.
- Profitability and efficiency ratios, such as EBITDA Margin, Return on Equity (ROE), and Inventory Turnover, provide insights into how well a company generates profits and uses its assets.
- Liquidity ratios, like the Current Ratio and Quick Ratio, indicate a company’s ability to meet its short-term obligations and manage financial risk.
- Valuation ratios, such as Price-to-Earnings (P/E) and Price-to-Book (P/B), help investors determine whether a company’s stock is fairly priced or overvalued.
