9 Most Important Financial Ratios & Their Meaning (2024)

9 Most Important Financial Ratios & Their Meaning (1)

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 debt2. Efficiency Ratios: Helps measure company’s efficiency in using its resources3. Profitability Ratios: Helps measure company’s ability to generate profits/income4. 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.

1. Current Ratio

Current ratio measures the company’s ability to repay short term loans with existing assets.Current Ratio Formula = Current Assets / Current LiabilitiesA 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

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 sharesA 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 StocksP/E RatioReturn on Capital EmployedDebt to EquityReturn on EquityPEG Ratio
Reliance Industries Limited32.310.70%0.4210.30%2.28
Tata Consultancy Services Limited34.747.80%0.0837.30%3.25
Hindustan Unilever Limited77.1117%0.0085.70%5.80
HDFC Bank Limited26.37.31%7.5616.50%1.28
Housing Development Finance Corporation Limited25.311.10%2.9719.20%1.28
Infosys Limited29.532.60%0.0725.30%4.95
Kotak Mahindra Bank Limited39.77.35%4.8613.70%1.76
Bharti Airtel Limited-5.45%2.699.83%-
ITC Limited18.332.60%-25.30%1.75
ICICI Bank Limited22.85.90%8.259.46%-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.To invest in the best stocks in India, open a Demat account with Samco -the best equity stockbroker awarded by CNBC-Awaaz and get Free brokerage trading for 1st month on all trades placed by the Samco App.Also,for beginners in the stockmarket, we have expertly curated readymade baskets for investments. Open a FREE account with StockBasket today and start creating infinite wealth!

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About The Author

9 Most Important Financial Ratios & Their Meaning (2)

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.

I'm Deepika Khude, a Certified Financial Planner with 5 years of experience in Investment Advisory and Financial Planning. My expertise lies in simplifying complex financial concepts with real-life stories and analogies. I aim to make common retail investors financially smart and independent.

Now, let's delve into the concepts mentioned in the article about financial ratios. Financial ratios play a crucial role in assessing a company's health and performance. They are derived from numerical data in financial statements and provide meaningful insights into various aspects of a company's financial condition. Here's an overview of the key concepts covered:

1. Meaning of Financial Ratios:

  • Financial ratios are numeric tools derived from financial statements to provide meaningful information about a company.
  • They are essential for investors who may not have the opportunity to meet a company's management or conduct an in-depth study of financials.

2. Importance of Financial Ratios:

  • Investors use financial ratios to understand a company's health.
  • They help in deciding whether to invest in a company or not.
  • Investors can track a company's performance and identify trends.
  • Comparison of a company's performance against competitors and the industry is facilitated.

3. Types of Financial Ratios:

  • Leverage Ratios: Measure a company's debt.
  • Efficiency Ratios: Measure a company's efficiency in using resources.
  • Profitability Ratios: Measure a company's ability to generate profits.
  • Liquidity Ratios: Assess a company's ability to repay short-term and long-term loans.
  • Market Value Ratios: Evaluate the share price of a company.

4. Liquidity Ratios:

  • Current Ratio: Measures the company’s ability to repay short-term loans with existing assets.
  • Quick Ratio (Acid-test Ratio): Evaluates a company's ability to repay short-term liabilities with quick assets.
  • Operating Cash Ratio: Highlights the number of times a company can pay off its liabilities from generated revenue.
  • Cash Ratio: Evaluates a company’s ability to repay short-term liabilities with cash and cash equivalents.

5. Leverage Ratios:

  • Debt to Equity Ratio: Shows the total debt of a company against shareholder’s equity.
  • Interest Coverage Ratios: Signifies a company's ability to pay its interest obligations.

6. Profitability Ratios:

  • Return on Equity Ratio: Highlights a company’s ability to generate profits using its equity capital.

7. Market Value Ratios:

  • Earnings Per Share (EPS) Ratio: Net income earned for every outstanding share.
  • Price to Equity (P/E) Ratio: Relative value of a company’s share price to its earnings.

The article also provides key financial ratios of top Indian companies, including P/E Ratio, Return on Capital Employed, Debt to Equity, Return on Equity, and PEG Ratio for companies like Reliance Industries, Tata Consultancy Services, Hindustan Unilever, HDFC Bank, and others.

In conclusion, understanding and analyzing these financial ratios are crucial for investors to make informed decisions about investing in stocks. These ratios provide insights into a company's financial health, performance, and potential risks.

9 Most Important Financial Ratios & Their Meaning (2024)

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