Financial Ratios Explained: The Simple Way to Analyse a Company’s Health
Why Are Financial Ratios Important?
Imagine you’re checking your own health. You might measure your temperature, check your cholesterol levels, or monitor your blood sugar. These numbers help you understand if your body is in good shape.
Similarly, financial ratios help us assess the financial health of a company. They act like “health indicators” for businesses, showing us how profitable, stable, and efficient a company is.
Whether you’re an investor, a business owner, or just someone curious about finance, understanding financial ratios can help you make better decisions. So, let’s dive in!
Types of Financial Ratios (The 5 Key Categories)
There are five main types of financial ratios, each serving a different purpose:
- Profitability Ratios – How well is a company making money?
- Liquidity Ratios – Can the company pay its short-term debts?
- Solvency Ratios – Is the company financially stable in the long run?
- Activity Ratios – How efficiently does the company use its assets?
- Valuation Ratios – Is the company’s stock fairly priced?
Let’s go through each one with examples.
1. Profitability Ratios: Measuring How Well a Company Makes Money
Profitability ratios tell us how good a company is at turning revenue into profit. The higher these numbers, the better the company is at making money.
Example: Profit Margin
- Formula: Net Profit ÷ Sales Revenue × 100
- If a company earns ₹30 profit for every ₹100 in sales, its profit margin is 30%.
- A higher profit margin means the company is better at controlling costs and making money.
Why does this matter?
If you’re an investor, you want to invest in companies with strong and growing profit margins. If you own a business, you want to improve your margins over time.
2. Liquidity Ratios: Can a Company Pay Its Short-Term Bills?
Liquidity ratios measure whether a company has enough cash (or assets) to cover its short-term debts. A company with low liquidity might struggle to pay salaries, rent, or suppliers.
Example: Current Ratio
- Formula: Current Assets ÷ Current Liabilities
- If a company has ₹200 crores in current assets and ₹100 crores in current liabilities, its current ratio is 2.0.
- A ratio above 1.0 means the company has enough short-term assets to cover its short-term debts.
Why does this matter?
- If a company has too low a ratio (below 1), it may struggle to pay bills.
- If it’s too high, it may not be using its resources efficiently.
3. Solvency Ratios: Checking a Company’s Long-Term Stability
While liquidity focuses on short-term debts, solvency ratios measure long-term financial stability. They tell us whether a company has taken on too much debt.
Example: Debt Ratio
- Formula: Total Liabilities ÷ Total Assets
- If a company has ₹800 crores in liabilities and ₹1,000 crores in assets, its debt ratio is 0.8 (or 80%).
- A higher debt ratio means the company is relying too much on borrowed money, which can be risky.
Why does this matter?
Companies with high debt may struggle to survive during economic downturns. Investors prefer businesses with a manageable debt level.
4. Activity Ratios: Measuring Efficiency
Activity ratios (also called efficiency ratios) show how well a company uses its assets to generate sales.
Example: Inventory Turnover Ratio
- Formula: Cost of Goods Sold ÷ Average Inventory
- If a shoe company sells ₹120 crores worth of shoes in a year and has an average inventory of ₹10 crores, its inventory turnover ratio is 12.
- This means the company sells and restocks its inventory 12 times a year.
Why does this matter?
A higher turnover ratio means the company is selling products quickly, which is usually a good sign. A lower ratio could mean slow-moving stock, which may lead to losses.
5. Valuation Ratios: Is a Stock Fairly Priced?
Valuation ratios help investors determine whether a company’s stock price is too high, too low, or fair.
Example: Price-to-Earnings (P/E) Ratio
- Formula: Current Stock Price ÷ Earnings Per Share (EPS)
- If a company’s stock price is ₹100 and its EPS is ₹10, its P/E ratio is 10.
- A lower P/E ratio suggests the stock might be undervalued (a good deal).
- A higher P/E ratio means investors are willing to pay more for each rupee of profit.
Why does this matter?
Investors compare the P/E ratio of different companies in the same industry to find undervalued stocks with growth potential.
Final Thoughts: Why You Should Use Financial Ratios
Whether you’re investing in stocks, running a business, or analysing a company, financial ratios give you a clear picture of financial health.
Here’s a quick summary:
✔ Profitability Ratios – Measure profit generation.
✔ Liquidity Ratios – Check short-term financial health.
✔ Solvency Ratios – Assess long-term stability.
✔ Activity Ratios – Show operational efficiency.
✔ Valuation Ratios – Help investors value a company’s stock.
Understanding these ratios will help you make smarter financial decisions—whether you’re investing in stocks or managing your own business.
Want to learn more? In future articles, we’ll dive deeper into each ratio with real-world examples. Stay tuned!
What’s Next?
- Have questions about financial ratios? Drop them in the comments!
- Want a deep dive into fundamental analysis? Check out our upcoming posts!
Frequently Asked Questions (FAQ) About Financial Ratios
1. What are financial ratios, and why are they important?
Financial ratios are mathematical calculations using financial statement data to assess a company’s profitability, liquidity, solvency, efficiency, and valuation. They help investors, analysts, and business owners make informed financial decisions.
2. How do financial ratios help investors?
Financial ratios help investors evaluate a company’s financial health, compare it with competitors, and determine whether its stock is overvalued, undervalued, or fairly priced. This is crucial in making smart investment decisions.
3. How do businesses use financial ratios?
Business owners use financial ratios to:
✔ Measure profitability and efficiency
✔ Check short-term liquidity and long-term financial stability
✔ Compare performance with industry benchmarks
✔ Make informed growth and investment decisions
4. Which financial ratios are most important for investors?
For investors, some key financial ratios include:
- P/E Ratio – To assess if a stock is fairly priced
- Profit Margin – To check how efficiently a company makes money
- Debt Ratio – To measure financial stability
- Current Ratio – To evaluate short-term liquidity
5. What is a good P/E ratio?
There is no universal “good” P/E ratio—it depends on the industry. A lower P/E ratio compared to industry peers may indicate an undervalued stock, while a higher one might suggest growth potential or overvaluation.
6. How do I calculate financial ratios?
Financial ratios are calculated using data from a company’s financial statements, including the income statement, balance sheet, and cash flow statement. Formulas are simple and usually involve dividing one financial metric by another.
7. Can financial ratios predict a company’s future performance?
Financial ratios don’t predict the future, but they help analyse past and present performance, which can give clues about future trends. Investors should use them alongside other research methods like industry analysis and market trends.
8. What are the limitations of financial ratios?
- Ratios don’t tell the full story—they should be used with other financial analysis tools.
- Different industries have different benchmarks, so comparing across industries can be misleading.
- Accounting methods can vary, affecting ratio accuracy.
9. Where can I find financial ratios for a company?
You can find financial ratios in:
- Company’s financial statements (Annual reports, quarterly filings)
- Stock market websites (Yahoo Finance, Bloomberg, NSE/BSE, etc.)
- Company investor presentations
10. How often should financial ratios be analysed?
It’s a good practice to analyse financial ratios quarterly and annually to track trends and make informed decisions. Investors should also review them before making buy/sell decisions in the stock market.
Disclaimer: The information provided in this article is for informational and educational purposes only and should not be considered financial, investment, or professional advice. While we strive for accuracy, we do not guarantee the completeness or reliability of the content. Always conduct your own research or consult a qualified financial advisor before making any investment decisions. MarketUnder.com and its authors are not responsible for any financial losses or decisions made based on this information.
