Financial ratios are powerful tools that help investors decode a company’s performance, stability, debt position, and market valuation. Instead of reading hundreds of pages in an annual report, these ratios offer a quick and insightful snapshot of how a business is really doing.
This guide breaks down the three major categories of financial ratios—Profitability, Leverage, and Valuation—and shows you how analysts use them to evaluate companies like Bajaj Auto.
1. What Are Financial Ratios?
Financial ratios are numerical indicators calculated from the Profit & Loss Statement, Balance Sheet, and Cash Flow Statement. They simplify complex financial data and help answer questions such as:
- Is the business profitable?
- Can it comfortably repay its loans?
- Is the stock expensive or undervalued?
- Is management efficient in using shareholder money?
Ratios are grouped into three broad categories:
- Profitability Ratios
- Leverage (Solvency) Ratios
- Valuation Ratios
2. Profitability Ratios
Profitability ratios reveal how efficiently a company generates profits from its operations and shareholder funds.
a) Operating Profit Margin (EBITDA Margin)
Formula:
EBITDA ÷ Revenue from Operations
EBITDA (earnings before interest, tax, depreciation, amortization) is calculated as:
Total Income – Total Expenses
A higher margin indicates better operational efficiency.
Example:
Bajaj Auto’s EBITDA margin ≈ 21%
b) PAT Margin (Net Profit Margin)
Formula:
PAT ÷ Total Income
This tells you the percentage of revenue that remains as net profit after all expenses, tax, and interest.
Example:
PAT margin ≈ 16.5%
A stable or rising PAT margin signals healthy business dynamics.
c) Return on Equity (ROE)
One of the most important profitability metrics.
Formula:
PAT ÷ Shareholders’ Equity
ROE measures how effectively the company uses shareholders’ money to generate profit.
Example:
Bajaj Auto’s ROE ≈ 24%
A higher ROE usually indicates better management and an efficient business model.
Important:
Avoid judging ROE without checking leverage. High debt can artificially inflate ROE.
3. Leverage (Solvency) Ratios
These ratios measure the company’s ability to service its debt and maintain long-term financial stability.
a) Interest Coverage Ratio
Formula:
EBITDA ÷ Interest Expense
This tells you how many times the business can pay its interest obligations.
Example (Assuming interest = ₹450 Cr):
Interest Coverage ≈ 14×
Higher is better.
Lower numbers indicate stress and financial risk.
b) Debt-to-Equity Ratio (D/E)
Formula:
Total Debt ÷ Total Equity
- D/E = 1: Equal amount of debt and equity
- D/E > 1: Highly leveraged, riskier
- D/E < 1: Strong equity base, lower financial risk
Example (Assumed):
If Debt = ₹5,500 Cr and Equity = ₹21,000 Cr →
D/E = 0.25
A low D/E is favorable for long-term investors.
4. Valuation Ratios
Valuation ratios help you judge whether the stock price reflects the company’s real worth.
a) Price-to-Sales Ratio (P/S)
Formula:
Share Price ÷ Sales per Share
First compute sales per share:
Total Sales ÷ Total Shares Outstanding
Example:
Sales per share ≈ ₹1,007
Share price ≈ ₹3,780
P/S = 3.75
Meaning:
For every ₹1 of sales, the market values the stock at ₹3.75.
Always compare P/S with peers and check PAT margins.
A company with higher margins deserves a higher P/S.
b) Price-to-Book Value Ratio (P/BV)
Before calculating P/BV, understand book value:
Book Value per Share = Total Equity ÷ Total Shares Outstanding
Book value represents the minimum worth of the company upon liquidation.
Example:
Book Value ≈ ₹750
Share price ≈ ₹3,780
P/BV ≈ 5
High P/BV: Market values the business above its book worth (possible overvaluation or strong growth prospects)
Low P/BV: Potential undervaluation
c) Price-to-Earnings Ratio (P/E)
One of the most widely used valuation metrics.
Step 1: Calculate EPS
Formula:
PAT ÷ Total Shares
EPS ≈ ₹180
Step 2: Calculate P/E
Formula:
Share Price ÷ EPS
P/E = 20×
If the share price rises to ₹5,000 while EPS remains the same:
P/E = 27.7×
P/E increases when prices rise faster than earnings.
Index Connection
Index P/E (like Nifty 50 P/E) helps gauge whether the market is:
- Cheap
- Fairly valued
- Expensive
5. How to Use Financial Ratios Effectively
✔ Never analyze ratios in isolation
✔ Compare with peers in the same industry
✔ Study multi-year trends, not just one year
✔ Check both qualitative and quantitative aspects
✔ Verify debt levels before judging profitability
✔ Use a combination of ratios for balanced decisions
Ratios simplify analysis, but they are only part of the bigger picture.
Management quality, governance, competitive strength, and industry outlook matter just as much.
Final Summary
Profitability Ratios
- EBITDA Margin
- PAT Margin
- ROE
Leverage Ratios
- Interest Coverage
- Debt-to-Equity
Valuation Ratios
- Price-to-Sales
- Price-to-Book
- Price-to-Earnings
Together, these metrics help you understand:
✔ How efficiently the company earns
✔ How safely it manages debt
✔ How the market values it
Used wisely, financial ratios become essential tools for intelligent investing.
%20(2).png)
0 Comments