Financial ratios are among the most powerful tools for evaluating a company. They help investors understand profitability, debt levels, valuation, and overall financial health without diving blindly into hundreds of pages of annual reports.
This article breaks down the major categories of financial ratios—Profitability, Leverage, and Valuation—and shows you how they are calculated using clear examples. By the end, you’ll know how to interpret these ratios like a professional analyst.
1. What Are Financial Ratios?
Financial ratios are numerical indicators derived from a company’s financial statements. They help you answer three fundamental questions:
- Is the company profitable?
- Is the company financially stable and capable of managing its debt?
- Is the stock priced fairly relative to its performance and assets?
To answer these, ratios are classified into three categories:
- Profitability Ratios
- Leverage (Solvency) Ratios
- Valuation Ratios
2. Profitability Ratios
Profitability ratios measure how efficiently a company generates profit from its operations and shareholder capital.
a) Operating Profit Margin (EBITDA Margin)
Formula:
EBITDA ÷ Revenue from Operations
EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) is calculated as:
Total Income – Total Expenses
A higher operating margin indicates a more efficient business with better cost control.
Example:
Bajaj Auto’s EBITDA margin is 21%, meaning the company retains ₹21 as operating profit for every ₹100 of revenue.
b) PAT Margin (Net Profit Margin)
Formula:
Profit After Tax (PAT) ÷ Total Income
In Bajaj Auto’s case, the PAT margin is 16.5%.
Higher margins reflect operational strength and better pricing power.
c) Return on Equity (ROE)
This is one of the most respected profitability indicators.
Formula:
PAT ÷ Shareholders’ Equity
ROE shows how much profit the company generates for each rupee of shareholder capital.
Example:
Bajaj Auto’s ROE is 24%, which is considered excellent.
Important Note:
If a company has large debt, ROE can appear inflated due to lower equity. Always check debt levels before interpreting ROE.
3. Leverage (Solvency) Ratios
These ratios measure how much debt a company carries and whether it can comfortably meet its obligations.
a) Interest Coverage Ratio
Formula:
EBITDA ÷ Interest Expense
This ratio tells you how many times the company can pay its interest obligations.
Example:
If EBITDA = 6,300 cr and assumed interest = 450 cr:
Interest coverage = 14 times
The higher the ratio, the safer the company.
b) Debt-to-Equity Ratio
Formula:
Total Debt ÷ Shareholders’ Equity
A D/E ratio of 1 means equal debt and equity.
More than 1 indicates heavy leverage.
Less than 1 suggests a strong equity base.
Example (Illustrative):
If Bajaj Auto hypothetically takes debt of 5,500 cr and equity is 21,000 cr:
Debt-to-Equity = 0.25
Lower is generally better and reflects financial stability.
4. Valuation Ratios
Valuation ratios help investors judge whether a stock is cheap or expensive relative to its performance.
a) Price-to-Sales Ratio (P/S)
Formula:
Share Price ÷ Sales per Share
Steps:
Calculate sales per shareTotal Sales ÷ Total Shares Outstanding
Divide share price by sales per share
Example:
Sales per share = ₹1,007
Current share price = ₹3,780
P/S = 3.75
Meaning:
For every ₹1 of sales, the market values Bajaj Auto at ₹3.75.
Important:
Compare P/S with competitors and check PAT margins.
Higher margins justify higher P/S.
b) Price-to-Book Ratio (P/BV)
Before calculating P/BV, understand book value:
Book Value = Shareholders’ Equity ÷ Shares Outstanding
It represents the minimum value shareholders would get if the company liquidates.
Example:
Book value per share = ₹750
Share price = ₹3,780
P/BV = 5
High P/BV may indicate the stock is overvalued;
Low P/BV may indicate undervaluation.
c) Price-to-Earnings Ratio (P/E)
One of the most widely used ratios.
Formula:
Share Price ÷ Earnings Per Share (EPS)
EPS = PAT ÷ Total Shares
Example:
EPS = ₹180
Share price = ₹3,780
P/E = 20x
If the share price increases to ₹5,000 (with EPS unchanged), P/E becomes 27.7x, indicating a more expensive valuation.
P/E can also be used to evaluate entire indices such as Nifty 50.
5. How to Use These Ratios Wisely
Never look at ratios in isolation.
To get meaningful insights:
✔ Compare ratios with competitors
✔ Study multi-year trends instead of single-year figures
✔ Combine quantitative ratios with qualitative analysis
✔ Check debt levels before making decisions
✔ Understand the business model and industry cycles
Financial ratios help you filter high-quality companies, but the final investment decision should include:
- Management quality
- Competitive advantage
- Industry outlook
- Cash flow strength
- Corporate governance
Key Takeaways
- Profitability ratios show earning power
- Leverage ratios show financial risk
- Valuation ratios show how the market prices the company
- Always compare ratios with peers
- Use both qualitative and quantitative inputs for informed decisions
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