Financial ratios convert company numbers into percentages revealing performance at a glance. Most investors ignore ratios thinking they’re complex—they’re not. Ratios answer one question: “Is this company performing better or worse than last year and competitors?”
Think of ratios like health metrics for companies. Heart rate, blood pressure, cholesterol—each metric shows different health angles. Financial ratios do the same.
Four Critical Ratio Categories
Liquidity Ratios show whether companies pay bills on time. Current Ratio divides current assets by current liabilities. Above 1.5 = healthy cash position. Below 1 = potential trouble. HDFC Bank’s current ratio sitting at 2.1 means it covers short-term debt twice over.
Financial Ratios Categories: Liquidity, Profitability, Solvency, Efficiency
Profitability Ratios reveal how much cash flows to the bottom line. Net Profit Margin (Net Income ÷ Revenue) shows profit per rupee of sales. Infosys at 22% net profit margin keeps ₹22 per every ₹100 earned—strong execution.
ROE (Return on Equity) measures how well management squeezes profits from shareholder money. High ROE means management isn’t wasting capital. ICICI Bank’s 15% ROE beats savings account returns—worthwhile.
Debt-to-Equity Ratio reveals leverage risk. Below 1.0 = healthy. Above 2.0 = dangerous levels. TCS at 0.8 = fortress balance sheet. Highly leveraged companies collapse when interest rates spike.
The ROE vs ROA Secret
ROE (Return on Equity) looks impressive but hides debt usage. ROA (Return on Assets) strips away debt showing true operational efficiency.
ROE vs ROA: Understanding Profitability and Asset Efficiency
Compare 25% ROE vs 10% ROA—huge gap screams “debt is boosting returns, not operations”. When interest rates climb, that debt kills profitability. That 15-point gap means leverage, not excellence.
Which Ratios Actually Matter?
To pick stocks: P/E ratio (valuation), ROE (management quality), Debt-to-Equity (safety), Current Ratio (solvency).
To compare peers: Look at all three profitability ratios together—Gross margin, Operating margin, Net margin. Declining margins despite stable revenue scream efficiency problems.
To avoid disasters: Debt-to-Equity above 3, Current Ratio below 0.8, ROE negative = stay away.
Fatal Mistakes Most Traders Make
Trading on single ratios produces disasters. High ROE looks attractive until checking debt leverage and discovering it’s unsustainable.
Comparing ratios across industries destroys analysis. Banks operate differently than software companies—debt levels shouldn’t match.
Ignoring ratio trends kills accounts. A company’s ROE declining from 18% to 12% over three years signals trouble regardless of today’s absolute number.
Most lethal: checking one ratio annually instead of quarterly. Quarterly tracking catches deterioration early before stock crashes.
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