What are Financial Ratios?

Fundamental analysis is a method that helps in understanding a company’s performance by reviewing key financial ratios that consider its profits, assets, debt, and shareholder value. The ratios provide a structured way to interpret financial statements and can help readers understand how a business generally manages earnings, capital, and resources. The concept often covers valuation ratios, profitability ratios, leverage ratios, and return-based measures that could support informed interpretation. This article explains the 5 financial ratios in a simple manner along with suitable examples. 

5 Key Financial Ratios Every Stock Investor Should Know 

Here are 5 important financial ratios explained along with their formulas and easy-to-understand examples. 

Price to Earnings (P/E) Ratio 

The P/E ratio is generally an indication of the relationship of the market price of any firm's stock to its earnings per share. It can help individuals understand how much investors may be willing to pay for each unit of reported earnings.  This ratio is usually considered a valuation indicator and can offer perspective on whether stock financial ratios appear relatively expensive or comparatively reasonable within their industry context. 

Formula: 

P/E Ratio = Market Price Per Share/Earnings Per Share 

Example 

If the stock price is ₹120 and the earning per share (EPS) is ₹12, then the value of the P/E ratio would be 10. This means investors are generally paying ten units of price for one unit of earnings.  

Return on Equity (RoE) Ratio  

The RoE ratio usually reflects how efficiently a company may be using shareholders’ equity to generate net income. This ratio can provide insight into how business resources are generally converted into returns for equity holders. This measure often helps in understanding operational efficiency and capital utilisation, although it is typically assessed together with leverage, earnings quality, and long-term sustainability rather than viewed independently. 

Formula: 

RoE = Net Income/Shareholder’s Equity 

Example: 

If a company reports net income of ₹24 lakh and shareholders’ equity of ₹120 lakh, its RoE becomes 20%. It could be an indication of the firm providing a return of twenty for every unit of equity provided. However, a high return on equity can often be achieved when its equity increases, with an enhancement in its borrowings. Therefore, it is generally expected from individuals to review RoE along with debt levels, asset performance, and sector averages to understand the broader financial position. 

Price-to-Book Ratio 

The P/B ratio is usually calculated by comparing the market price with the book value on a per-share basis. The book value typically represents the net value of assets, after subtracting the value of liabilities from the total value of assets, according to the financial statement. This ratio can help indicate how the market may be valuing a company’s asset base. The ratio might also assist in understanding whether the market value of shares is aligned with the net value of assets. 

Formula: 

P/B Ratio = Market Price Per Share/Book Value Per Share 

Example: 

If the book value per share is ₹50 and the market price per share is ₹150, the P/B ratio becomes 3. This generally means the market is valuing the company at three times its recorded book value. The interpretation can vary across sectors, as asset-heavy industries may usually display different ranges when compared with service-based sectors. Hence, this ratio may be more meaningful when compared within the same industry and assessed along with earnings stability and business fundamentals. 

Dividend-Price Ratio 

The main implication of the dividend yield ratio could be related to how much of the dividend a stockholder can get in relation to the market value of a share of stock. It can help understand how a portion of company earnings is distributed to shareholders, especially in businesses that generally focus on regular dividend payouts. This ratio may be useful for those who prefer income-oriented equity exposure rather than only relying on price appreciation. 

Formula: 

Dividend Yield = Dividend Per Share/Market Value Per Share 

Example: 

Suppose the company is paying an annual dividend of ₹6 per share and the market price is ₹120. This results in a dividend yield of 5%. This may raise an indication that the shareholders may receive five units of dividend for every hundred units that have been invested based on the current market price. However, this aspect might be affected based on the company's policy and profitability.  

Debt-to-Equity (D/E) Ratio 

The D/E ratio typically indicates the extent to which a firm can finance the capital structure through debts relative to the equity.  It can help indicate the level of financial leverage and the extent to which operations could be dependent on borrowed funds. Moderate amounts of borrowing may be helpful in expanding a business; however, too much borrowing could at times raise their payments of interest.  

Formula: 

D/E Ratio = Total Liabilities/Total Shareholders’ Equity 

Example: 

Suppose the total liabilities and the shareholders’ fund amount to ₹200 lakh and ₹100 lakh, respectively. Then the D/E ratio would be 2. This is generally interpreted as the company having twice as much debt as the equity. While this ratio may be appropriate for different sectors, depending upon the intensity level and nature of the industry the company belongs to, this ratio is generally taken into consideration along with the profitability and consistency of income generated by the company. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

Knowing the key financial ratios is important for making an overall assessment of the company’s performance. P/E ratio, return of equity, price to book, dividend yield, and debt-to-equity ratios help investors make informed and systematic decisions related to investment. Evaluating these ratios may help investors make informed decisions related to their investment. Additionally, using an online trading app for accessing financial data and interpreting these ratios, investors can make more informed and strategic investment decisions.