A Word of Caution About Financial Ratio Analysis - Financial Management

Throughout the analysis of the Drake Manufacturing Company, we emphasized that an analyst must exercise caution when evaluating a firm’s financial ratios. Although ratios can provide valuable information, they can also be misleading for a number of reasons.

First, ratios are only as reliable as the accounting data on which they are based. The financial statements of most U.S. companies are prepared in accordance with generally accepted accounting principles (GAAP). In the United States, the Financial Accounting Standards Board issues Statements of Financial Accounting Standards (SFAS), which describe accounting rules that companies must follow in preparing their financial statements. Even though careful financial analysis can provide excellent insights into the direction and relative strength of the firm, the financial analyst must keep in mind that GAAP gives firms considerable latitude in reporting their financial positions, as is evident in this chapter’s “Financial Challenge.” Different firms follow different accounting procedures for inventory valuation, depreciation, reporting long-term leases, pension fund contributions, and mergers and acquisitions, to name just a few.

These, in turn, affect reported earnings, assets, and owners’ investments. Unless the analyst makes adjustments for accounting reporting differences, ratio comparisons between individual companies and with various industry norms cannot be viewed as definitive.

Second, with the exception of disclosing upper and lower quartile values, firms that compile industry norms often do not report information about the dispersion, or distribution, of the individual values around the mean ratio. If the reported ratios are dispersed widely, the industry average will be of questionable value because it may not reflect the socalled typical firm in the industry.

Furthermore, the standard of comparison probably should not be the “typical” firm but rather the better -performing firms in the industry. Without some measure of dispersion, however, ratios for these better-performing firms cannot be determined.

Third, valid comparative analysis depends on the availability of data for appropriately defined industries. Some industry classifications are either too broad or too narrow to be reliable sources of comparative data when an analyst is evaluating a particular firm. Most firms operate in more than one industry, which makes analysis more difficult. Fourth, it is important to remember that financial ratios provide a historic record of the performance and financial condition of a firm. Further analysis is required before this historic record can be used as a basis for future projections.

Finally, comparisons of a firm’s ratios with industry norms may not always be what they seem. Ratios comparing unfavorably with industry norms should be construed as red flags indicating the need for further investigation —not signals of impending doom. On the other hand, even if a firm’s ratios compare favorably with those of the better -performing firms in the industry, it does not necessarily mean the firm is performing adequately.

If, for example, the industry itself is experiencing a declining demand for its goods and services, favorable ratio comparisons may simply indicate that a firm is not decaying as rapidly as the typical firm in the industry. Thus, comparisons of selected ratios—particularly those relating to profitability —must be made with national industry averages in order to determine whether a particular firm in a particular industry is justified in making further investments.

In summary, ratios should not be viewed as substitutes for sound business judgment. Instead, they are simply tools that can help management make better decisions.

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