The Most Important Financial Ratios

A ratio doesn't tell me what to do — it tells me what to ask next.

• Explain what specific question a ratio like P/E or ROE is answering, rather than treating it as just a number to look up.
• Calculate P/E (Price per Share ÷ Earnings per Share) and ROE (Net Profit ÷ Shareholder's Equity) from given figures.
• Judge whether a P/E or ROE value is high or low only by comparing it to a peer, benchmark, or the company's own history — not in isolation.
• Distinguish a ratio as a clue to investigate further from a ratio as a final verdict on whether a company is good or bad.

Here's why this matters: you're about to see numbers like "P/E: 20" or "ROE: 15%" everywhere you look — on apps, in news, on screeners. If you don't know what question a number is answering, you'll do what most beginners do: treat a low number as "cheap and good" and a high number as "expensive and bad," and end up wrong more often than right.

So what is a ratio, really? A ratio is a question about a business, compressed into one number. Before you use any ratio, ask: what question is this actually asking?

Take the P/E Ratio (Price-to-Earnings). Its formula is:

P/E = Price per Share ÷ Earnings per Share (EPS)

The question it answers is: "How much am I paying today for each rupee of profit this company makes?" A P/E of 20 means you're paying ₹20 for every ₹1 of current profit. That's it — it doesn't say the company is good or bad, cheap or expensive, on its own.

The number never carries its own meaning; the comparison does.

Now take ROE (Return on Equity). Its formula is:

ROE = Net Profit ÷ Shareholder's Equity

Shareholder's Equity is the money that belongs to the owners of the company — what's left after subtracting what the company owes from what it owns. ROE answers a different question: "How well does this company turn the money its owners gave it into profit?" A higher ROE means the company is more efficient at using owners' money to generate profit.

Notice something about both formulas: one part always comes from the market (like share price), and the other part always comes from the company's financial statements (like EPS, net profit, or equity). A ratio pairs a market fact with a business fact.

Now the turn: knowing the formula and the question isn't enough — you still can't say if a P/E of 20 is high or low without something to compare it to. A P/E of 20 might be expensive for a slow-growing utility company but perfectly normal for a fast-growing tech company. The number never carries its own meaning; the comparison does. So you compare it against the company's own past P/E, against a close competitor, or against the industry average. Only then does the number turn into evidence you can actually use.

And one more limit to respect: both P/E and ROE are calculated from past financial statements. They tell you what already happened — how the company performed last year, what investors are paying today. They don't promise what will happen next year. So even a well-compared ratio is a clue about the business's current state, not a guarantee about its future.

Let's put real numbers to this. Two listed Indian FMCG companies — Company A and Company B — are sitting side by side on a stock screener.

Company A trades at ₹200 per share, with an EPS of ₹10. That gives a P/E of ₹200 ÷ ₹10 = 20.

Company B trades at ₹80 per share, with an EPS of ₹8. That gives a P/E of ₹80 ÷ ₹8 = 10.

At this point, most beginners would stop right here and say "Company B is cheaper — I'm paying only 10 times its earnings versus 20 times for Company A. B is the better buy." That's the exact trap the misconception sets: low P/E treated as an automatic verdict.

But hold on — let's ask what other question we can put to these companies. Let's check ROE.

Company A has a Net Profit of ₹50 crore and Shareholder's Equity of ₹250 crore. ROE = ₹50 crore ÷ ₹250 crore = 20%.

Company B has a Net Profit of ₹20 crore and Shareholder's Equity of ₹200 crore. ROE = ₹20 crore ÷ ₹200 crore = 10%.

Now the picture flips. Company A is turning shareholder money into profit twice as efficiently as Company B — 20% versus 10%. Yes, you're paying more per rupee of Company A's profit today (P/E of 20 vs. 10), but you're also buying into a company that squeezes far more profit out of every rupee shareholders have put in.

Seen alone, P/E made Company B look like the obvious pick. Seen alongside ROE, the choice is no longer obvious at all — it's now a genuine trade-off worth investigating further, not a snap decision. That's the whole lesson in one table: neither ratio, by itself, was a verdict. Each was one clue, and only looking at them together turned the clues into a real question worth researching further.

Point: A ratio only becomes useful once paired with another ratio or a comparison point — the 'cheaper' company by P/E was actually less efficient by ROE, so neither number alone was a verdict.

• Assuming a low P/E always means a stock is 'cheap' and worth buying, and a high P/E always means it's 'expensive' and worth avoiding. — Screeners and news headlines flash P/E as a simple cheap/expensive label, and since it's the most commonly quoted ratio, it feels like it must be a complete verdict on its own. Fix: Treat P/E only as answering 'how much am I paying per rupee of current profit?' — then always compare it to the company's own history or its industry peers before calling it cheap or expensive.
• Deciding a company is 'good' or 'bad' based on just one ratio, like ROE or P/E alone. — Beginners want one simple number that removes the need for judgment, and financial media often quotes a single ratio as if it settles the matter. Fix: Remember every ratio answers only one narrow question. Look at at least two ratios together (like P/E and ROE, as in the example) before forming any opinion about the business.
• Assuming ratios calculated from past financial statements predict how the company will perform in the future. — Since ratios are used to make forward-looking investment decisions, it's easy to assume the numbers themselves are forecasts rather than history. Fix: Remind yourself that a ratio is a snapshot of the past and present — accurate evidence to weigh, but never a promise about what comes next.

• A ratio is a question about a business compressed into a number — know the question before you trust the number.
• P/E = Price per Share ÷ EPS, and it asks: how much am I paying per rupee of current profit?
• ROE = Net Profit ÷ Shareholder's Equity, and it asks: how efficiently does the company turn owners' money into profit?
• A ratio only means something once compared — to the company's own past, a peer, or an industry benchmark.
• Ratios describe the past honestly; they are clues to investigate, never a verdict and never a promise about the future.

Q1. What is the correct formula for the P/E Ratio?

• Price per Share ÷ Earnings per Share
• Net Profit ÷ Shareholder's Equity
• Earnings per Share ÷ Price per Share
• Shareholder's Equity ÷ Net Profit Answer: Price per Share ÷ Earnings per Share — P/E is calculated as Price per Share divided by Earnings per Share (EPS). It answers the question: how much am I paying today for each rupee of profit?

Q2. ROE (Return on Equity) is best described as a number that answers which question?

• How much am I paying today for each rupee of profit?
• How well does the company turn shareholders' money into profit?
• How much debt does the company owe compared to its assets?
• How fast is the company's share price rising? Answer: How well does the company turn shareholders' money into profit? — ROE = Net Profit ÷ Shareholder's Equity, so it measures how efficiently a company uses the money its owners have put in to generate profit.

Q3. A ratio like P/E is meaningful on its own, without comparing it to anything else. Answer: False — A ratio only becomes useful evidence once it's compared to something — the company's own history, a peer, or an industry benchmark. On its own, a number like 'P/E of 20' doesn't tell you if it's high or low.

Q4. You see Company X with a very low P/E and immediately think 'this must be a great, cheap buy.' Based on what you've learned, what should you do before deciding anything?

• Buy the stock right away since a low P/E always signals a bargain
• Check what the low P/E is being compared against, and look at another ratio like ROE before forming any opinion
• Ignore P/E entirely since it never matters
• Assume the company will keep performing this well in the future since the P/E is historical proof Answer: Check what the low P/E is being compared against, and look at another ratio like ROE before forming any opinion — A single ratio is a clue, not a verdict. Before judging the company, you should ask what the P/E is being compared to and check it alongside another ratio like ROE to get a fuller picture.

Q5. Company X: P/E 12, ROE sliding 15% → 12% → 9% over three years. Company Y: P/E 22, ROE steady at 18%. Your friend says: "X is obviously cheaper, going with X." What's she missing? Reveal: Weak: picks a side using P/E alone. Strong: notices ROE isn't just lower — it's declining. A falling ROE next to a low P/E is a reason the market may be pricing X down for cause, not a bargain.