If you’re new to investing or trying to better understand the financial health of businesses in India, you may have come across the term financial ratios. These ratios are essential tools that help investors assess the performance of a company and its ability to generate profits, manage debts, and cover financial obligations.
This detailed guide will explain the most important financial ratios you need to understand as a beginner investor in India. We will break down each ratio in simple terms and provide examples to help you get started.
What Are Financial Ratios?
At the core, financial ratios are numbers that help you evaluate a company’s financial health. These ratios are derived from the company’s balance sheet and income statement, two important documents that give insight into a company’s assets, liabilities, profits, and expenses. By analyzing these ratios, investors can get a quick snapshot of a company’s overall financial situation.
For anyone looking to invest in Indian stocks listed on exchanges like the NSE (National Stock Exchange) or the BSE (Bombay Stock Exchange), understanding financial ratios is crucial. They provide vital information on a company’s liquidity, profitability, and solvency.
The 6 Most Important Financial Ratios for Investors in India
There are many financial ratios used to evaluate a company, but we will focus on the six most important ones every beginner investor should know. These ratios cover a range of financial factors, helping you assess the company’s financial position from different angles.
1. Working Capital Ratio: Can the Company Pay Its Short-Term Bills?
The working capital ratio measures a company’s ability to meet its short-term obligations with its short-term assets.
In simple terms, it shows whether the company has enough resources to pay its upcoming bills like loans, wages, and accounts payable.
Formula: Working Capital Ratio = Current Assets ÷ Current Liabilities
- Current Assets: These are the assets that can be easily converted into cash within one year. Examples include cash, accounts receivable (money owed by customers), and inventory.
- Current Liabilities: These are short-term obligations that the company must pay within the next 12 months. Examples include accounts payable (money owed to suppliers) and short-term loans.
Example:
Let’s say an Indian company has ₹8 crore in current assets and ₹4 crore in current liabilities. The working capital ratio would be:
Working Capital Ratio = ₹8 crore ÷ ₹4 crore = 2
This means the company has twice as many assets as it needs to cover its short-term debts. A ratio of 2 is considered a positive sign because it shows the company can pay off its obligations and still have some money left over.
If the working capital ratio is less than 1, this could be a red flag. It suggests the company may not have enough resources to cover its short-term debts, which could lead to financial difficulties.
2. Quick Ratio: Can the Company Pay Its Bills Without Selling Inventory?
The quick ratio is a stricter measure of a company’s liquidity than the working capital ratio. It excludes inventory (products the company sells) and prepaid expenses (payments made in advance for services or goods) from the calculation.
This is because inventory can take time to sell, so it might not be readily available for paying bills.
Formula: Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) ÷ Current Liabilities
Example:
Suppose a company has ₹8 crore in total current assets, but ₹2 crore of that is tied up in inventory and prepaid expenses. If its current liabilities are ₹4 crore, the quick ratio would be:
Quick Ratio = (₹8 crore – ₹2 crore) ÷ ₹4 crore = ₹6 crore ÷ ₹4 crore = 1.5
This means the company has ₹1.50 in liquid assets for every ₹1 it owes in the short term. A quick ratio of 1 or higher is generally considered healthy because it indicates the company can pay its bills without having to sell inventory.
If the quick ratio is below 1, it suggests the company may face difficulties paying its short-term obligations.
3. Earnings Per Share (EPS): How Much Profit Does the Company Make for Each Share?
Earnings Per Share (EPS) is a key indicator of a company’s profitability. It shows how much profit a company makes for each share of its stock. Investors use EPS to measure how profitable a company is, especially when comparing different companies in the same industry.
Formula: EPS = Net Income ÷ Average Number of Shares Outstanding
- Net Income: The total profit a company earns after all expenses (like taxes and operating costs) are subtracted from revenue.
- Average Number of Shares Outstanding: This is the total number of shares that the company has issued to investors.
Example:
If a company in India reports net income of ₹10 crore and has 1 crore shares outstanding, the EPS would be:
EPS = ₹10 crore ÷ 1 crore shares = ₹10
This means each share of the company generated ₹10 in profit. A higher EPS indicates that the company is making more profit, which is generally a good sign for investors.
4. Price-to-Earnings (P/E) Ratio: How Expensive Is the Stock?
The Price-to-Earnings (P/E) ratio helps you understand how expensive or cheap a company’s stock is based on its earnings.
It tells you how much investors are willing to pay for every ₹1 of profit the company makes. This ratio is especially useful when comparing companies within the same industry.
Formula: P/E Ratio = Stock Price ÷ EPS
Example:
If an Indian company’s stock price is ₹100 and its EPS is ₹5, the P/E ratio would be:
P/E Ratio = ₹100 ÷ ₹5 = 20
This means investors are willing to pay ₹20 for every ₹1 of profit the company generates.
A high P/E ratio suggests that investors expect strong future growth, while a low P/E ratio might indicate the stock is undervalued or that the company is facing challenges.
However, remember that P/E ratios vary between industries, so it’s important to compare a company’s P/E ratio with others in the same sector.
5. Debt-to-Equity (D/E) Ratio: How Much Debt Does the Company Have?
The Debt-to-Equity (D/E) ratio shows the relationship between a company’s debt and its equity (shareholder investments).
A higher D/E ratio suggests that the company is more dependent on borrowing (debt), which can be risky, especially if it faces financial trouble and cannot repay its loans.
Formula: D/E Ratio = Total Liabilities ÷ Shareholders’ Equity
- Total Liabilities: All debts and financial obligations of the company.
- Shareholders’ Equity: The total value of the company’s assets minus its liabilities, representing the ownership interest of its shareholders.
Example:
If an Indian company has ₹20 crore in total liabilities and ₹50 crore in shareholder equity, the D/E ratio would be:
D/E Ratio = ₹20 crore ÷ ₹50 crore = 0.4
This means the company has ₹0.40 in debt for every ₹1 of equity. A D/E ratio of 0.4 is considered low risk, but some industries like real estate and infrastructure tend to have higher D/E ratios due to the nature of their business, which involves heavy capital investment.
6. Return on Equity (ROE): How Well Does the Company Use Investors’ Money?
Return on Equity (ROE) measures how effectively a company uses its shareholders’ money to generate profits. The higher the ROE, the better the company is at using the capital invested by shareholders to make a profit.
Formula: ROE = Net Income ÷ Shareholders’ Equity
Example:
If a company has net income of ₹5 crore and shareholders’ equity of ₹25 crore, the ROE would be:
ROE = ₹5 crore ÷ ₹25 crore = 20%
This means the company generates a 20% return on the equity invested by its shareholders. A higher ROE is a good indicator of a company’s profitability and efficient use of capital.
How to Use These Ratios in the Indian Context
Each of these ratios provides valuable insights into different aspects of a company’s financial health. However, it’s essential to look at these ratios together to get a complete picture.
For example, a company with a high P/E ratio may appear attractive, but if its quick ratio is low, it could be a risky investment. Always use a combination of ratios to evaluate a company’s overall performance.
Also, remember that different industries have different benchmarks for these ratios.
For example, technology companies in India often have higher P/E ratios due to expected growth, while companies in industries like utilities or FMCG (Fast Moving Consumer Goods) may have lower P/E ratios because their earnings are more stable.
The Bottom Line
Understanding and analyzing these six key financial ratios will help you make smarter, more informed investment decisions when evaluating companies listed on the NSE or BSE. These ratios give you a snapshot of a company’s liquidity, profitability, and solvency, which are crucial factors to consider when making investment choices.
Key Takeaways:
- Financial ratios help you assess a company’s financial health.
- The six key ratios every beginner investor should know are working capital ratio, quick ratio, EPS, P/E ratio, D/E ratio, and ROE.
- Use a combination of ratios to evaluate a company, as relying on a single ratio may be misleading.
- Compare a company’s ratios with industry averages to gauge its performance relative to peers in the Indian market.
By understanding these essential ratios, you’ll be better equipped to make informed decisions when choosing stocks or evaluating potential investment opportunities in Indian companies.
