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# Using ratios to analyse companies

Introduction| Course| Q&As | Recommended reading| Quiz | 133

### 1. Why bother with ratios?

Ratios are calculated from numbers. The attraction of ratios is that numbers are, in theory at least, scientific and 'hard' whereas non-numerical yardsticks are ambiguous and 'soft'. They should therefore be reliable indicators of a company's performance.

This ignores the years of practice which managers of public companies, assisted by the accountancy profession, have had in presenting numbers in a flattering light. Numbers, it transpires, can be ambiguous, misleading and open to many interpretations, just like words.

Nevertheless, investors have to start somewhere, and as a rule, numbers are the best place to start. Ratios simply relate one set of numbers to another, and provide a basis for comparing the performance of a company year to year and in relation to its competitors.

The numbers on which ratios depend come from two main sources:

1. Report and Accounts

This is the main source of historical information on a company's sales, assets, liabilities, pre-tax profits, borrowings, and other liabilities. When putting together a company's Report and Accounts, its directors and auditors have to follow Companies Act law and conform to accountancy profession rules which makes comparative analysis easier.

2. Market prices

A number of key investor ratios use the current share price as one of the variables.

You can be a successful investor without ever doing any ratio analysis, but your chances of success increase significantly if you have a grip of the numbers.

 1. Why bother with ratios? 2. A word of warning 3. The P&L and the balance sheet 4. Grouping the ratios 5. Profit margin 6. Return on capital employed (ROCE) 7. Sales as a multiple of capital employed 8. Stockturn 9. Debt collection 10. Payment of trade creditors 11. Cash-to-cash cycle 12. Gearing 13. Interest cover 14. Current ratio 15. Quick ratio (acid test) 16. Earnings ratios 17. Dividend ratios 18. Other ratios 19. Sources of information 20. Conclusion