Question

Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry?

Answer 1

Sometimes, it is misleading to compare a company’s financial ratios with those of other firms that operate in the same industry.

This is because :

• Although they operate in the same industry, the sub-industry or sub-sector may be different, which results in different financial dynamics. For example, the ratios of two firms in the transportation industry may not be comparable because one firm operates in the railway sector, and the other in the trucking sector
• The riskiness of the business may vary between the two firms due to the type of projects undertaken. For example, a construction firm that undertakes short-term projects will have lower risk than a construction firm that undertakes long-term projects. Comparing the ratios will give a misleading picture of the comparative financial condition
• Profitability and turnover ratios may be different for two firms due to the type of business. For example, a retailer of general merchandise will have lower profitability and higher turnover ratios than a retailer of electronic goods.