Ratio Analysis - Introduction

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Ratio Analysis - Introduction

Ratio analysis is an accounting tool, which can be used to measure the solvency, the profitability, and the overall financial strength of a business, by analysing its financial accounts (specifically the balance sheet and the profit and loss account).

Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention.

There are five main categories of accounting ratio:

  1. Liquidity ratios, these measure the solvency of the business and its ability to meet short-term debts.
  2. Profitability (or 'performance') ratios, these analyse the profit made over the last year.
  3. Financial efficiency (or 'activity') ratios, these analyse the efficiency of the business in terms of the use of its resources in generating sales.
  4. Gearing ratio, this measures the proportion of the capital of the business which has come from external sources, and must be repaid with interest.
  5. Shareholders' ratios, these measure the strength of the company, its share price and its dividends.

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