Financial analysis can look like an intimidating alphabet soup of ratios. In practice, a small number of them, understood well and tracked over time, tells a long-term investor most of what matters about a business. Here are five worth knowing.
Return on equity (ROE) measures how much profit a company generates on the shareholders' money it employs. A consistently high ROE, not propped up by excessive debt, is one of the clearest signs of a quality business.
Debt-to-equity tells you how much the company relies on borrowing. Debt magnifies returns in good times and losses in bad; a business that can grow without piling on debt is more resilient when conditions turn.
The price-to-earnings (P/E) ratio is the most quoted and most abused. It tells you how many rupees you pay for each rupee of annual profit. It is only meaningful in context — compared with the company's own history and with its peers — never in isolation.
Operating margin shows how much of each rupee of sales survives as operating profit. Rising margins suggest pricing power or improving efficiency; falling margins are an early warning.
Free cash flow — the cash left after running and maintaining the business — is arguably the most honest number of all, because it is far harder to dress up than accounting profit. A company that consistently converts profit into real cash has options: to reinvest, repay debt, or reward shareholders.
You will notice these ratios reinforce each other. Track them across several years rather than a single quarter, compare like with like, and you will have a sturdier view of a business than most headlines provide.