Understanding Financial Ratios

To invest in any company’s stock/ETF, you assess various numbers and invest if it aligns with your personal investment goals. This process is called Financial Analysis.

Financial analysis can be done with the help of financial ratios. These ratios help us understand the performance of the company, and compare it to the performance of previous years as well as the performance of other companies in the same industry.

Here, we will go over a few financial ratios to understand what they mean, how they are calculated, and what the ratios look like in a favourable scenario.

Stock & ETF smallcases

PE Ratio

One of the most prominent financial ratios is P/E ratio. The Price-to-earnings ratio is a measure of the current stock price of a company against earnings per share (EPS). EPS in essence is how much profit each share is generating.

Basically, the price of the stock you as an investor need to pay if that company generated ₹1 earnings. In essence, if factors like industry, quality and sustainability of earnings are the same, then the lower the PE Ratio, the better for you as an investor.

PB Ratio

The other well-known financial ratio is P/B ratio. The Price-to-book ratio is a measure of the current stock price of a company against the book value per share (BVPS). Book value per share is an amalgamation of assets and liabilities. In simple terms is when you pay off all liabilities from existing assets. (assets minus liabilities)

Assets – cash in the bank, investments made by the company, etc; 
Liabilities – loans, debts, goods bought in credit, etc

This number helps you evaluate if you as an investor, are overpaying for the stock. The lower the PB Ratio, the better for you as an investor. 

Sharpe Ratio

Sharpe ratio measures the risk-adjusted return of an investment. It shows how much return is generated for the level of risk taken.

A higher Sharpe ratio is better, as it indicates that the portfolio has generated higher returns for the same amount of risk taken.

Dividend Yield

When a company periodically pays its shareholders an amount from its profits, it is called a dividend. The Dividend Yield Ratio helps you calculate how much dividend you would make per stock against the amount you invest in buying the stock.

Watch out for this ratio if annual dividends are an important part of your investment goals. The higher the Dividend Yield, the better for you as an investor.

Guess what?

Ratios like PE and PB ratio can be calculated for a smallcase as well. Treat the basket of stocks, as one company stock (total the prices and earnings of all the stocks) and apply the same formula.

Mutual Fund smallcases

Sharpe Ratio

The Sharpe ratio measures the risk-adjusted return of an investment. It shows how much return is generated for the level of risk taken.

A higher Sharpe ratio is better, as it indicates that the portfolio has generated higher returns for the same amount of risk taken.

Expense Ratio

Expense ratio is the annual operating cost of a mutual fund, expressed as a percentage of the fund’s average assets. These costs are deducted from the fund’s returns.

A lower expense ratio is generally better, as it means lower costs for the investor.

For Mutual Fund smallcases, the expense ratio is calculated as a weighted average of the expense ratios of the mutual funds in the smallcase.

Example

If a Mutual Fund smallcase has:

• MF 1: Weight 25%, Expense Ratio 0.5
  
• MF 2: Weight 30%, Expense Ratio 0.2
  
• MF 3: Weight 45%, Expense Ratio 0.7
  

Then the expense ratio is:

25% × 0.5 + 30% × 0.2 + 45% × 0.7 = 0.5

This gives a single expense ratio that represents the overall cost of holding the Mutual Fund smallcase.

How to use these ratios?

Financial ratios help you understand and compare smallcases, but they do not predict future returns.

Each ratio highlights a different characteristic of a smallcase — such as valuation, risk-adjusted performance, income, or costs. No single ratio is enough on its own.

These ratios are most useful when you compare similar smallcases and view them together, rather than focusing on just one number. They are meant to provide additional context, along with factors like your investment goals and time horizon.

FAQs