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ratio analysis
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Ratio analysis Ratio analysis is the organisation of information in financial statements to enable or permit entities (I.e. companies, sole traders etc) of the financial statements to deduce conclusions regarding their financial performance. It is the initial stage in assessing an entity and it serves as a foundation for providing entities with relevant information which aids their decision of what to investigate further. However, ratios can be expressed as a percentage, as a fraction or as a proportion. They are presented according to the needs of the users of the information. Although, it is possible to calculate a large number of ratios, not all ratios are beneficial to users. The only ratios that may be worth calculating are those that are based on key relationships and are therefore meaningful to users. However, there are many groups of people who are interested in using ratios. Some of these groups are shareholders, lenders, customers, suppliers, employers, government agencies and competitors. Ratio analysis can be used to review trends and compare similar entities with each other in terms of their financial performance. It also simplifies financial statements so that readers can interpret and usefully apply it to their maximum satisfaction which otherwise would have been uninformative and misinterpreted by readers except those who posses very high skills. Ratios can be grouped into five categories. Each individual category indicates a certain aspect of financial performance. These five categories are profitability, efficiency, solvency, investment and gearing and under these categories are various ratios. Profitability indicates how well a company is performing. The primary objective of businesses coming into existence is solely depended on profits. Therefore profitability ratios indicates the extent to which this purpose is achieved, taking into consideration the performance of management and a company’s performance relative to its competitors, hence sharing the worth of investing in a company. Efficiency measures the extent to which resources are utilised by entities to generate output. It may be affected by factors such as shortage of skilled labour or deliberate under production of output to maximise profitability. The third category is solvency which is also known as liquidity. It is measured by the ability of entities to ensure that their debts are paid at the appropriate time and likewise the ability of debtors to pay the correct amount they owe to entities. This is very essential to businesses as they can only remain solvent by ensuring the availability of adequate resources. Solvency aids in judging whether or not businesses posses a good financial status before being granted loans. Investment is the fourth category and it indicates the performance of entities in relation to the number and price of their shares and dividends. Last but not least there is gearing which is concerned with the relationship that exists between the financial contribution made by the owners of a business and the contribution by outsiders, and its impact on the financial decision making by managers. However, under these five categories are various ratios. But for this assignment, I’m going to identify and describe six of these ratios. The six key ratios are Return on capital employed (R.O.C.E) Current ratio Acid test ratio Stock turnover Gearing and price/earning ratio Firstly, return on capital employed ratio compares the profit earned before interest and taxation to the funds used to generate that return (which is usually the total of all suppliers of long-term finance before any deductions for interest payable to lenders or payments of dividends to shareholders are made).
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