Ratios turn financial statements into comparable numbers. They let you set a large company beside a small one, or a company beside its own past. The list below covers the ones students meet first, with the formula and a note on what each measures. Keep in mind that ratios describe a company’s statements; they do not tell you what is a good level without context.
Profitability
Operating margin = operating profit ÷ revenue. How much of each rupee of sales remains after running costs.
Net profit margin = profit after tax ÷ revenue. The share of sales left after all costs, interest and tax.
Return on equity (ROE) = profit after tax ÷ average shareholders’ equity. Profit relative to the owners’ money in the business.
Return on capital employed (ROCE) = EBIT ÷ (total assets − current liabilities). Operating profit relative to the capital in use.
Liquidity
Current ratio = current assets ÷ current liabilities. Whether short-term assets cover short-term obligations.
Quick ratio = (current assets − inventory) ÷ current liabilities. A stricter test that leaves out stock, which may be slow to sell.
Leverage
Debt-to-equity = total debt ÷ shareholders’ equity. How much of the funding comes from borrowing.
Interest coverage = EBIT ÷ interest expense. How many times operating profit covers interest.
Efficiency
Asset turnover = revenue ÷ average total assets. Sales generated per rupee of assets.
Inventory days = average inventory ÷ cost of goods sold × 365. How long stock sits before being sold.
Receivable days = average receivables ÷ revenue × 365. How long customers take to pay.
A worked example
A fictional firm, Vindhya Tools, has revenue ₹200 crore, operating profit ₹30 crore, profit after tax ₹16 crore, equity ₹100 crore, debt ₹50 crore, EBIT ₹28 crore and interest ₹7 crore.
Operating margin: 30 ÷ 200 = 15%.
Net margin: 16 ÷ 200 = 8%.
ROE: 16 ÷ 100 = 16%.
Debt-to-equity: 50 ÷ 100 = 0.5.
Interest coverage: 28 ÷ 7 = 4 times.
Using ratios carefully
Compare within the same industry. A retailer’s inventory days will differ from a software firm’s.
Use averages of opening and closing balances where the formula says so.
Check definitions. Some sources use closing equity, others average; some use total debt, others include only borrowings.
Look at trends over several periods rather than a single value.
The DuPont view of ROE
ROE can be split into three parts: net profit margin × asset turnover × equity multiplier (total assets ÷ equity). For Vindhya Tools, assume total assets of ₹160 crore. Net margin is 8%, asset turnover is 200 ÷ 160 = 1.25, and the equity multiplier is 160 ÷ 100 = 1.6. Multiplying gives 0.08 × 1.25 × 1.6 = 16%, matching the ROE. The split shows where returns come from: profitability, how hard the assets work, or how much borrowing is used. Two companies with the same ROE can be built very differently.
Comparing two different businesses
Take a fictional retailer and a fictional software firm. The retailer has a net margin of 3%, asset turnover of 3.0 and an equity multiplier of 2.0, giving an ROE of 18%. The software firm has a net margin of 20%, asset turnover of 0.6 and an equity multiplier of 1.5, also giving an ROE of 18%. The same ROE comes from thin margins and fast turnover in one case, and fat margins and slow turnover in the other. Comparing their margins alone would be misleading; the ratio belongs to the business model.
Pitfalls
Averages and closing balances. Some formulas use average equity or assets for the period; others use the closing figure. State which you used.
Quarterly figures. Ratios built from a quarter’s profit need to be annualised before they are compared with annual ratios.
One-offs. An exceptional gain can inflate a profitability ratio for a single period.
Negative equity. ROE has no useful meaning if equity is negative or very small.
Banks. Many of the ratios above are not appropriate for banks and financial companies, whose statements and funding differ. Banks have their own measures.
A routine for using ratios
Choose a small set of ratios you understand and apply them consistently.
Calculate them for at least four periods so that you see trends.
Put the company beside two or three others in the same industry.
Go back to the statements to find the reason behind any large change.
What ratios cannot do
They compress a statement into a number, which means they leave out context: the quality of management, the legal environment, the competitive position. They describe the past, and a ratio that looked healthy a year ago can have changed. Treat them as questions to ask of the statements, not as answers about the company.
Keep a one-page list of formulas next to your notes. After a few weeks, the formulas will be familiar, and you can spend your time on the more interesting question of why a ratio moved.
A one-page reference is useful, but you also want the reasoning beside each formula. A fuller version, with explanations alongside the formulas, is available as a cheat-sheet of common financial ratios if you want to print or bookmark it.
Ratios answer “how much” questions. They work best when paired with the “why” in the notes to the accounts. The inputs come from the statements themselves, described in the three financial statements in plain language.
