Financial ratios, each explained in one sentence
A ratio is just one number divided by another so you can compare things of different sizes. There are hundreds. Seven will cover almost everything a beginner needs.
Last checked August 2026.
The short version
- Ratios exist to compare companies of different sizes fairly.
- No ratio means anything alone. Compare against similar companies and against the company own history.
- tells you how good the business is. tells you how much you are paying for it.
- can be flattered by , so always read the two together.
- A ratio built on distorted profit is a distorted ratio. Check the profit line first.
Why ratios exist
A company earning ₹500 crore sounds better than one earning ₹50 crore, until you learn the first employs ten times the capital to do it. Absolute numbers cannot be compared across companies of different sizes. Ratios can.
Two rules apply to every ratio in this lesson, and skipping them is how people misuse them.
- Compare like with like. A bank and a software company have completely different normal ranges for almost every ratio. Comparing across industries produces nonsense.
- Compare against the company own history. A PE of 30 means one thing for a business that has averaged 18, and something else for one that has averaged 45.
Ratios that tell you how good the business is
Return on capital employed (ROCE)
measures profit against all the capital the business uses, both borrowed and owned. If you were only allowed one ratio, this would be a strong candidate.
A business consistently earning 20% or more on its capital is doing something others find hard to copy. One earning 8% is working hard for little. Because it includes borrowed money, ROCE is difficult to flatter with debt, which makes it more honest than ROE.
Return on equity (ROE)
measures profit against only the owners money. It is widely quoted and it has a specific trap: borrowing more raises ROE even when the business has not improved at all.
A company with 25% ROE and almost no debt is genuinely excellent. A company with 25% ROE and heavy borrowing has bought that number, and it will fall apart in a bad year. Always read ROE next to .
Operating margin
is operating profit as a percentage of . It shows the gap between what a company charges and what it costs to deliver.
The direction matters more than the level. A widening margin suggests pricing power or improving efficiency. A narrowing one usually means competition or rising input costs, and it often shows up before profit growth slows.
Ratios that tell you how safe it is
Debt to equity
compares borrowed money against owner money. More debt magnifies both good years and bad ones, because interest has to be paid regardless.
What counts as high varies enormously. A bank is highly leveraged by design. A software company with any meaningful debt is unusual. This is why cross-industry comparison is meaningless here.
Interest coverage
Operating profit divided by interest cost. It answers a simple question: how many times over can this business pay the interest on its borrowings?
A coverage of 8 means comfortable. A coverage of 1.5 means a moderately bad year could leave the company unable to service its debt. This ratio has predicted more corporate trouble than almost any other, and it is barely mentioned in beginner guides.
Cash conversion
Not a formal ratio, but the habit is essential. Compare cash from operations against reported over several years. If profit consistently exceeds cash generated, the profit is being recognised faster than money is arriving. See .
Ratios that tell you what you are paying
PE ratio
is the share price divided by earnings per share. A PE of 25 means you are paying ₹25 for every ₹1 of annual profit per share.
The number alone says nothing about value. A high PE reflects expected growth, which may be justified. A low PE can mean a bargain or a business in decline. What a PE actually measures is how much room you have to be wrong.
Two cautions. First, a PE built on a year containing a one-off gain is meaningless. Second, in cyclical industries the PE looks lowest at the top of the cycle, when profits peak just before falling. That is the reverse of what it appears to say.
Price to book
compares the share price with the company per share. It is genuinely useful for banks and other asset-heavy businesses whose value sits in things the accounts can measure.
It is close to useless for a company whose value is a brand, a network or software, because those barely appear in book value. A ratio below one is not automatically a bargain either. It can mean the market expects the assets to be worth less than the accounts claim.
Dividend yield
The annual divided by the share price. Covered fully in dividend investing, including why the highest yields are usually the least trustworthy.
Reading them together
Individual ratios mislead. Combinations rarely do. Here is what a few common patterns usually mean.
| Pattern | Usually means |
|---|---|
| High ROCE, low debt, steady margin | A genuinely good business. The question becomes price. |
| High ROE, high debt, thin interest coverage | Returns bought with borrowing. Fragile in a downturn. |
| Low PE, falling margin, rising debt | Often a value trap rather than a bargain. |
| High PE, high ROCE, growing revenue | A quality business at a full price. The risk is the price, not the business. |
| Rising profit, falling operating cash | Investigate before doing anything else. |
And a final honest note. Ratios are calculated from reported figures. If those figures are distorted, whether by one-off items, aggressive accounting or something worse, every ratio built on them inherits the distortion. Ratios are a starting point for questions, not an answer.
What to remember
- Ratios exist to compare companies of different sizes. They are meaningless across different industries.
- ROCE is the most honest measure of business quality, because debt cannot flatter it.
- ROE rises when a company borrows more, so always read it alongside debt to equity.
- Interest coverage predicts corporate trouble better than almost any other ratio.
- PE measures how much room you have to be wrong, not whether something is cheap.
- Judge the business first, then the price. Never the other way round.