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9 Most Important Financial Ratios & Their Meaning

Author Deepika Khude | Posted December 29, 2020

 Important Financial Ratios

Meaning of Financial Ratios

Financial ratios are created with the use of numerical which are taken from financial statements to gain meaningful information about a company.

It might not be possible for every investor to meet a company’s management or do an in-depth study of their financials. 

In such situations, financial ratios are key to understanding the health of the company. As it provides beneficial information about the company such as balance sheets, cash flow and income statements etc. 

Financial ratios are the perfect tool for investors to measure the health of a company. 

Importance of Financial Ratios

It is essential for investors to understand key financial ratios, their meaning and impact on the stocks.  Financial Ratios help: 

  • Investors in deciding whether to invest in a company or not. 
  • Investors track the company’s performance and can help early identification of trends. 
  • Investors compare the performance of the company against its competitors and industry as a whole. 

Types of Financial Ratios

Financial Ratios are divided into various types based on the information that they provide. The key types of financial ratios are: 

1. Leverage Ratios: Helps measure company’s debt

2. Efficiency Ratios: Helps measure company’s efficiency in using its resources

3. Profitability Ratios: Helps measure company’s ability to generate profits/income

4. Liquidity Ratios: Helps understand company’s ability to repay short-term and long-term loans. 

5. Market Value Ratios: Helps evaluate the share price of a company. 

While there are several types of financial ratios, today we will understand the meaning and formulas of the 9 most basic financial ratios.

Financial Ratios – Types, Meaning & Formulas

Liquidity Ratios

Liquidity ratios such as current ratio, acid-test ratio etc helps investors understand if the company has enough assets to repay its short-term and long-term loans. 

Let us understand the key types of liquidity ratios, their formulas and what they mean for an investor. 

Watch this video to understand liquidity ratio

1. Current Ratio

 Current ratio measures the company’s ability to repay short term loans with existing assets. 

Current Ratio Formula = Current Assets / Current Liabilities 

A high current ratio means that the company has sufficient cash to meet short term liabilities and is financially strong. Whereas, a low current ratio reflects poor financial health and may also indicate default. 

2. Quick Ratio

Quick ratio is also known as Acid-test ratio and evaluates a company’s ability to repay its short term liabilities with its quick assets. 

Quick Ratio/Acid-test Ratio Formula: Current assets – Inventories / Current Liabilities

3. Operating Cash Ratio

This financial ratio highlights the number of times a company can pay off its liabilities from generated revenue. 

Operating cash Ratio Formula: Operating cash flow / Current Liabilities

4. Cash Ratio

 Cash ratio evaluates a company’s ability to repay its short term liabilities with cash and cash equivalents. 

Cash Ratio Formula: Cash & Cash Equivalents / Current Liabilities 

Leverage Ratios

Leverage ratios show the debt (borrowings) of a company. Debt to Equity ratio is one of the most important ratios to analyse a company.

1. Debt to Equity Ratios

 Debt to Equity ratio shows the total debt of a company against shareholder’s equity. A high debt to equity ratio is not a favourable sign for equity investors as it signifies high risk. 

Debt to Equity Ratio Formula: Total Liabilities / Shareholder’s Equity

Watch this video to understand debt to equity ratio

2. Interest Coverage Ratios

 This financial ratio signifies a company’s ability to pay its interest obligations. High interest coverage ratio means that the company can make timely interest payments and is a good sign for debt investors. 

Interest Coverage Ratios Formulas: Operating Income/Interest Expenses

Profitability Ratios

Profitability ratios like ‘Return on Equity’ ratio highlights a company’s ability to generate profits (returns) using its equity capital. 

Return on Equity Ratio Formula: Net Income / Shareholder’s Equity

Market Value Ratios

Market Value ratios help in evaluating whether the stock prices are undervalued or overvalued. Earnings Per Share (EPS) & Price-to-Equity (P/E) ratios are some of the most important financial ratios. 

1. Earnings Per Share (EPS) Ratio

 Earnings per share is the net income earned for every outstanding share. 

Earnings per share formula: Net Income / Total outstanding shares

A high EPS ratio means that the investment is worthwhile and the company is capable of generating high dividends for its equity shareholders. 

2. Price to Equity (P/E) Ratio

P/E ratio is one of the most important ratios to analyse a company. P/E ratio helps investors understand the relative value of a company’s share price to its earnings. 

Price to Equity Ratio Formula: Share Price / Earnings Per Share

Key Financial Ratios of Top Indian Companies

Top Stocks P/E Ratio Return on Capital Employed Debt to Equity Return on Equity PEG Ratio
Reliance Industries Limited 32.3 10.70% 0.42 10.30% 2.28
Tata Consultancy Services Limited 34.7 47.80% 0.08 37.30% 3.25
Hindustan Unilever Limited 77.1 117% 0.00 85.70% 5.80
HDFC Bank Limited 26.3 7.31% 7.56 16.50% 1.28
Housing Development Finance Corporation Limited 25.3 11.10% 2.97 19.20% 1.28
Infosys Limited 29.5 32.60% 0.07 25.30% 4.95
Kotak Mahindra Bank Limited 39.7 7.35% 4.86 13.70% 1.76
Bharti Airtel Limited 5.45% 2.69 9.83%
ITC Limited 18.3 32.60% 25.30% 1.75
ICICI Bank Limited 22.8 5.90% 8.25 9.46% -8.15

Final Thoughts

P/E ratio, Earnings per share, return on capital, debt to equity ratio are some of the most important ratios to analyse a company. But merely calculating financial ratios will not help you discover the best stocks to buy. 

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By Deepika Khude

The author is a Certified Financial Planner (CFP) with 5 years experience in Investment Advisory and Financial Planning. Her strength lies in simplifying complex financial concepts with real life stories and analogies. Her goal is to make common retail investors financially smart and independent.

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