The Sharpe ratio answers the most important question in fund evaluation: was the return worth the risk? A fund that made 12% with violent swings can be a worse deal than one that made 8% calmly — Sharpe is the tool that reveals this.
The calculation starts with the excess return: the fund's return minus the risk-free rate (what a near-guaranteed alternative such as short-term government instruments would have paid). That excess is then divided by the fund's volatility. The result: extra return per unit of risk.
Reading it: higher is better. A negative Sharpe means the fund didn't even compensate you for leaving the safe alternative. Fair comparison is within the same category over the same period — comparing an equity fund's Sharpe to a money market fund's tells you little, as the two categories are different animals.
Its limits: it is built on history, treats upside and downside swings equally, and does not capture rare severe events. An excellent starting point for comparison — not a final verdict.