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2.4.2 Interpretation and Context

Financial ratios can only be interpreted in conjunction with other information and data, including benchmarks. In general, the financial ratios of a company are compared with those of its competitors and to the company’s prior periods. The goal is to understand the underlying causes of divergence between a company's ratios and those of the industry in which it's operating.

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Points to be kept in mind while evaluating ratios of a company:

  • Industry: A company can only be compared with others within its industry by relating its financial ratios to industry norms or to a subset of the companies in an industry. When industry norms are used to make judgments, care must be taken because many ratios are industry specific, and not all ratios are important to all industries.
  • Company Goals and strategy: Ratios can be compared with company's objectives to determine whether objectives are being attained and whether the results are consistent with the strategy.
  • Economic Environment: Ratios are to be seen in conjunction with the macroeconomic environment. If the environment is strong and company is cyclical then the company will show bad results in recession. Therefore, financial ratios should be examined in light of the current phase of the business cycle.

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