Investing becomes easier when you can interpret a company’s numbers. While financial statements contain a wealth of data, raw figures alone do not show whether a business is stable, profitable, or efficient.
This is where financial ratios help. Ratios convert complex financial figures into simple comparisons that reveal a company’s strength, weakness, and overall performance.

Ratios do not forecast the future, but they provide a clearer picture of how a business is performing today. They help identify trends, uncover risks, and highlight areas needing attention. When used correctly, ratios act as a filter that helps investors focus on companies with consistent performance.

What Are Financial Ratios?

A financial ratio compares two related numbers from a company’s financial statements.
For example:

• Profit compared to revenue shows how much the company earns per rupee sold.
  
• Debt compared to equity shows how dependent the company is on borrowed funds.
  

Ratios simplify large sets of numbers into meaningful signals.

Why Are Ratios Important in the Stock Market?

Ratios make financial data easier to understand. Investors use them to:

• Compare companies within the same sector
  
• Track a company’s progress over time
  
• Evaluate strengths and weaknesses
  
• Make fair comparisons between companies of different sizes
  

By converting financial information into proportional values, ratios provide clarity and improve decision-making.

How Are Ratios Helpful in Evaluation?

Ratios offer quick insights into:

• Profitability
• Stability
• Cash generation
• Short-term and long-term financial health
• Resource management
  

They help investors assess whether a company can survive downturns, handle debt, and grow sustainably.

Types of Financial Ratios

Financial ratios are grouped into five broad categories. Each offers a different view of a company’s performance.

1. Solvency Ratios

Solvency ratios measure a company’s ability to meet long-term financial commitments.
They are crucial because highly leveraged businesses face higher risk, especially during economic slowdowns or rising interest rate cycles.

Key Solvency Ratios

Debt-to-Equity Ratio:

Compares total debt to shareholder equity. A higher number indicates heavier reliance on borrowed funds.

Interest Coverage Ratio:

Measures how comfortably a company can pay interest on its debt. Higher values show stronger financial stability.

Together, these ratios indicate whether a company can sustain operations without long-term financial strain.

2. Profitability Ratios

Profitability ratios reflect how effectively a company converts revenue into profit.
They indicate efficiency, competitiveness, and overall financial health.

Key Profitability Ratios

Net Profit Margin:

Shows the percentage of profit left after all expenses.

Operating Margin:

Highlights the profitability of core business operations.

Return on Equity (ROE):

Shows how effectively the company uses shareholders’ capital.

Return on Assets (ROA):

Measures how efficiently the business uses its assets to generate earnings.

Strong profitability ratios suggest a robust business model.

3. Liquidity Ratios

Liquidity ratios measure a company’s short-term financial strength.
They indicate whether a company has enough liquid assets to pay bills and meet immediate obligations.

Key Liquidity Ratios

Current Ratio:

Compares current assets to current liabilities. A ratio above 1 generally signals good short-term health.

Quick Ratio:

A stricter measure excluding inventory. Shows how quickly assets can be converted into cash.

Liquidity ratios help assess a company’s ability to manage day-to-day operations without financial strain.

4. Cash Flow Ratios

Cash flow ratios reveal how effectively a company converts revenue into actual cash.
A company might show profits on paper yet struggle if cash generation is weak.

Key Cash Flow Ratios

Operating Cash Flow Ratio:
Measures cash generated from operations relative to current liabilities.

Cash Conversion Ratio:
Shows how efficiently a company converts sales into cash.

These ratios provide a practical view of financial strength and help highlight companies that may be profitable but cash-poor.

5. Efficiency Ratios

Efficiency ratios measure how well a company uses its resources, such as assets, inventory, and receivables.

Key Efficiency Ratios

Inventory Turnover:

Shows how often inventory is sold and replaced. Higher values indicate efficient operations.

Receivables Turnover:

Measures how quickly customers pay their dues.

Asset Turnover:

Shows how much revenue is generated per unit of assets.

Companies with high efficiency ratios typically operate smoothly, manage working capital well, and generate consistent returns.

Conclusion

Financial ratio analysis provides a structured and reliable way to evaluate a company’s performance.

• Solvency ratios reveal long-term safety.
• Profitability ratios highlight earnings strength.
• Liquidity and cash flow ratios show short-term financial health.
• Efficiency ratios measure operational effectiveness.

By understanding these ratios, investors can make informed decisions and identify strong, stable, and well-managed companies for investing. Ratios may not be the only tool in stock analysis, but they form a dependable starting point for evaluating any company.