Financial ratios are numbers which can help investors interpret the financial performance, health, and efficiency of a company.
Although financial ratios can seem like an attractive tool to make quick judgments about a company, in isolation, a financial ratio conveys little information and, in some cases, can even be misleading.
One of the most popular financial ratios, the price to earnings (PE) ratio, is used by a lot of investors to somehow judge the "value" of a company which may or may not always make sense. Avenue Supermarts, a chain of supermarkets across India, operating under the brand name DMart, made its debut on the NSE on 21st March 2017 at a PE ratio of approximately 105 and since then it has rarely exhibited a PE ratio of less than 90.
Of course, this doesn't mean that PE ratio isn't useful, but one should know how and, more importantly, when to use it. That goes for all financial ratios we're going to talk about.
All that being said, financial ratios can become a powerful tool in an investor's repertoire if
the method of calculation of the ratio in question is accurate
the ratio in question is calculated for a period of time (we suggest looking at, at least, the past 5 years of financial statements) to create a trend of how the company has performed
the ratio in question for a company is compared against its peers and an industry wide analysis is performed
When we say trend, think of Google Trends. Plotting financial ratio data points on a graph over a period of time would tell us a lot about how a company is evolving. Similarly, comparing these trends in financial ratios data against industry peers helps us gauge whether the evolution of the company is satisfactory and competitive.
In the following sections, we'll take a look at various financial ratios, their implications, and their relevance across different sectors.