Understanding financial ratios: Different types and how to use them

Whether you’re an investor, a business owner, or simply someone curious about how companies evaluate their performance, financial ratios offer a quick way to assess business health. They act like performance indicators on a company’s financial report card.

Let’s break down the most important types of financial ratios, with simple examples for each.

1. Liquidity Ratios (Can the company pay its short-term bills?)

These ratios measure a company’s ability to meet short-term obligations.

• Current Ratio:
  Formula: Current Assets / Current Liabilities
  Example: If a company has Rs 50 lakh in current assets and Rs 25 lakh in current liabilities,
  Current Ratio = 2.0 (which means it can cover its short-term dues twice over)

• Quick Ratio (Acid-Test Ratio):
  Formula: (Current Assets – Inventory) / Current Liabilities
  Example: Same company with Rs 10 lakh worth of inventory:
  Quick Ratio = (50 – 10) / 25 = 1.6

2. Profitability Ratios (Is the company making enough money from sales?)

These show how efficiently a company converts sales into profits.

• Gross Profit Margin:
  Formula: (Revenue – Cost of Goods Sold) / Revenue
  Example: If revenue is Rs 1 crore and COGS is Rs 60 lakh:
  Gross Profit Margin = 40%

• Net Profit Margin:
  Formula: Net Profit / Revenue
  Example: If Net Profit is Rs 8 lakh on sales of Rs 1 crore:
  Net Profit Margin = 8%

• Return on Equity (ROE):
  Formula: Net Profit / Shareholder Equity
  If Net Profit is Rs 10 lakh and equity is Rs 50 lakh:
  ROE = 20%

3. Leverage Ratios (Is the company taking too much debt?)

These measure the extent of financial leverage.

• Debt-to-Equity Ratio:
  Formula: Total Debt / Shareholder’s Equity
  Example: If Debt = Rs 40 lakh and Equity = Rs 50 lakh:
  Debt-to-Equity = 0.8 (A ratio below 1 is usually seen as conservative)

• Interest Coverage Ratio:
  Formula: EBIT / Interest Expense
  If EBIT is Rs 15 lakh and Interest Expense is Rs 3 lakh:
  Interest Coverage = 5 times (Meaning it earns 5 times more than its interest obligations)

4. Efficiency Ratios (How well is the company using its assets?)

These indicate how effectively the company uses its resources.

• Inventory Turnover Ratio:
  Formula: Cost of Goods Sold / Average Inventory
  Example: If COGS = Rs 1 crore and Avg Inventory = Rs 20 lakh:
  Inventory Turnover = 5 times (Meaning inventory cycles 5 times a year)

• Asset Turnover Ratio:
  Formula: Revenue / Total Assets
  If Revenue = Rs 2 crore and Assets = Rs 1 crore:
  Asset Turnover = 2 times

5. Valuation Ratios (Is the stock expensive or cheap?)

Used mostly by investors.

• Price-to-Earnings (P/E) Ratio:
  Formula: Share Price / Earnings per Share (EPS)
  If share price is Rs 200 and EPS is Rs 10:
  P/E = 20 times (Means investors are paying Rs 20 for every Re 1 of earnings)

• Price-to-Book (P/B) Ratio:
  Formula: Market Price per Share / Book Value per Share
  If Market Price = Rs 300 and Book Value = Rs 150:
  P/B = 2.0

Summary:

Final Tip:

Always compare ratios against industry averages and historical company data. One ratio alone never tells the full story.