Understanding financial ratios: Different types and how to use them

Business Upturn

14 hours ago

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.
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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:
Ratio Type Example Ratio Why it matters Liquidity Current Ratio Can the company pay bills soon? Profitability Net Profit Margin How much is it earning from sales? Leverage Debt-to-Equity Ratio Is it over-borrowed? Efficiency Inventory Turnover Is it using assets well? Valuation P/E Ratio Is the stock cheap or expensive?
Final Tip:
Always compare ratios against industry averages and historical company data. One ratio alone never tells the full story.