Chapter 9: Ratio Analysis
In order to assess a company, most people immediately look at its profit history. While this is one of the parameters for assessing a company, it could be misleading to take a decision based solely on this criterion. As we have seen in Chapter 8, Preparing a Cash Flow Statement, profits do not always equate to cash and even the most profitable company can fold if its profits are not backed up by cash flow.
Ratio analysis looks at the profitability, liquidity, asset management/efficiency, debt management, and market value of a company in order to give a much more reliable basis for making a decision. Each ratio takes two strategic items from the financial statements and examines the relationship between them in order to gain some insight into the profitability, liquidity, and so on of the company – for example, the ratio of turnover to gross profit. These are two significant items in the statement of comprehensive income in financial statements.
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