Question

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

Answer 1

It is sometimes misleading to compare a company’s financial ratios with those of other firms operating in the same industry because of the following:

i) One company is in maturity stage (big company) and the other company is in high growth stage (or say start up company which is in beginning stage):

In this case there is a possibility for the small company to have negative net income or negative cash flows. So, comparing the two companies using ratio analysis will yield inappropriate results. There might be a possibility for the small firm to grow big in future, but if we compare the two companies using ratios, then it will not indicate the same.

ii) Accounting fraud:
Some companies manipulate the financials to get better ratios. Comparing these ratios with the financial ratios of other companies would definitely show the fraud company as the better one which is a trap.

iii) Performance
Past performance does not guarantee future performance or value creation. Suppose one company has performed well in past but due to certain situations the company is going to experience loss in sales in future. Comparing past ratios of these types of companies will show misleading results.

iv)Quality of earnings
Suppose the "other income" of a company is higher compared to the revenue from operations and the company is generating higher net income because of the non operational or other income. Though the ratios may show a better picture but there is a possibility of the core business losing its ground which is not good for the company in long run. Comparing the ratios of such companies would give misleading results.