Question

How does inflation distort ratio analysis comparisons for one company over time (trend analysis) and for different companies that are being compared? Are only balance sheet items or both balance sheet and income statement items affected?

Answer 1

As we know that the inflation causes the earnings to increase in the income statement, however, it is possible that there is no actual increase in the volume of revenue. But the issue is that the book value of assets that actually produce the revenues and also the depreciation expense annually remains at historic values therefore, it does not reflect the actual cost that would incur if those assets are replaced.

For instance, the ROA of a company will tend to increase over the years if there is inflation even though the assets that are generating the cash flows are generating the exact same volume of sales.

Hence, the financial ratios comparison in which current values are compared with historic values tend to get distorted in trend analysis.

When we compare different companies then the company’s assets age will majorly affect the financial ratios. If for instance a company’s assets were purchased earlier than the other company then it is going to show lower asset values than the other company which purchased assets at a later date when the prices got inflated.

So two companies with almost same assets and revenues could’ve significantly different Return on assets (ROAs). Under inflation, it affects anything that is associated with the money, therefore, the financial ratios is going to reflect differences in the way the companies treat their inventories.

Hence, the inflation affects both the income statement and the balance sheet items.