Ratios are shortcuts. They compress a financial statement into a number you can compare, and that compression is both why they are useful and why they mislead.
This covers the ones worth knowing, what question each is actually asking, and — more usefully — the specific situations where a good-looking ratio means the opposite of what it appears to.
Valuation: what you are paying
P/E, price to earnings. Price divided by earnings per share. Asks: how many years of current profit am I paying for this. A high number means the market expects growth, not that the share is expensive in any absolute sense.
Where it misleads. A cyclical business at the top of its cycle shows a low P/E because earnings are peaking, and that is precisely when it is most dangerous. The reverse is also true — a cyclical at the bottom shows a high or negative P/E and may be the better entry. Commodity, metal and auto businesses are where this catches people most.
P/B, price to book. Price against net asset value. Meaningful for banks and asset-heavy businesses, close to meaningless for a software company whose value is people and code rather than anything on the balance sheet.
EV/EBITDA. Enterprise value against operating earnings before interest, tax, depreciation and amortisation. More comparable across companies with different debt levels than P/E is, because it counts debt in the numerator. Its weakness is that ignoring depreciation flatters businesses that must keep replacing assets.
No valuation ratio tells you whether something is worth buying. They tell you what expectations are already priced in, and your job is to decide whether those expectations are reasonable.
Profitability: how good the business is
ROE, return on equity. Profit against shareholders' funds. The single most useful profitability number, because it asks what the business earns on the money owners have put in.
Where it misleads, and this one is important. ROE can be raised by taking on debt rather than by improving the business. A company that borrows heavily and buys back shares shows a spectacular ROE and is more fragile than before. Always read ROE alongside the debt level, never alone.
ROCE, return on capital employed. Profit against all capital, debt included. Harder to flatter with leverage, which makes it the better number of the two for comparing businesses.
Operating margin. Operating profit as a percentage of revenue. Direction over three years matters more than the level, and margins differ enormously between industries so cross-sector comparison is meaningless.
Financial health: whether it survives a bad year
Debt to equity. Borrowings against shareholders' funds. What counts as high depends entirely on the industry — a bank's balance sheet looks alarming by manufacturing standards and is normal for a bank.
Interest coverage. Operating profit divided by interest cost. How many times over the company can pay its interest from what it earns. Falling coverage is a more urgent signal than rising debt, because it means the burden is growing faster than the ability to carry it.
Current ratio. Current assets against current liabilities. Below one means short-term obligations exceed short-term resources, which deserves an explanation.
Where these mislead. All three read only what is on the balance sheet. Contingent liabilities, guarantees given for group companies and disputed tax demands sit in the notes and appear in no ratio. A company with excellent ratios and a contingent liability larger than its net worth is not what the ratios suggest.
Efficiency, and the pair that catches deterioration first
Receivable days. How long customers take to pay. Inventory days. How long stock sits before selling.
These two are the early-warning system, and they move before profit does. A business whose receivable days went from 45 to 90 over two years is either selling to customers who cannot pay or booking revenue it will struggle to collect, and the profit statement will look fine for several quarters while that develops.
Read them together as the cash conversion cycle — how long money is tied up between paying suppliers and collecting from customers. A lengthening cycle in a business reporting growth is one of the more reliable warnings available to a retail investor, and it requires no judgement, only subtraction.
Asset turnover completes the picture: revenue against total assets, or how much business is generated per rupee of assets. Useful for comparing companies within the same industry and misleading across industries.
The four rules that stop ratios misleading you
Compare within an industry, never across. A software company and a steel plant have structurally different ratios and neither is better for it. A number is only meaningful against peers doing the same thing.
Direction beats level. One year is a photograph. Three years of the same ratio is a story, and the story is what you are after.
Ask which statement it came from. A ratio built on profit inherits every judgement in the profit calculation. One built on cash inherits far fewer. When they disagree, believe the cash.
Never buy on a ratio. A screen that surfaces low P/E and high ROE will hand you cyclicals at their peak and leveraged companies flattering their returns. Screens are for producing a shortlist to investigate, not a list to buy.
That last one is where most retail damage happens. The ratio is the beginning of the work, and it feels like the end of it.
Company filings are free on the exchange websites, and most broker platforms compute the common ratios beside the price.
Your broker computes most of these
Three years of figures, which is the view that matters. Free to open·₹0 delivery brokerage
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Frequently Asked Questions
Which financial ratios matter most for stock analysis?
ROCE for how good the business is, interest coverage for whether it survives a bad year, receivable and inventory days for early deterioration, and a valuation ratio appropriate to the industry. Direction over three years matters more than any single level.
Is a low P/E a good sign?
Not reliably. A cyclical business at the top of its cycle shows a low P/E precisely because earnings are peaking, which is the most dangerous point to buy. The reverse also holds - a high or negative P/E at the bottom of a cycle can be the better entry.
Why is ROCE better than ROE?
ROE can be raised by borrowing rather than by improving the business, so a heavily indebted company can show a spectacular ROE while being more fragile. ROCE counts all capital including debt, which is harder to flatter with leverage.
Which ratios warn you first that something is wrong?
Receivable days and inventory days. They move before profit does - a business whose receivable days went from 45 to 90 over two years has a developing problem that the profit statement will not show for several quarters.
Can I pick stocks using a ratio screener?
Only to produce a shortlist. A screen for low P/E and high ROE will hand you cyclicals at their peak and leveraged companies flattering their returns. The ratio is the start of the work, which is exactly why it feels like the end of it.
Related Reading
- How to read a balance sheet
- How to read a cash flow statement
- Dividend investing in India
- Index funds vs stocks
- Stock Market for Beginners - full syllabus
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