Question

Determine why it is sometimes misleading to compare a company’s financial ratios with those of other firms that operate within the same industry. Support your response with one (1) example from your research.

Answer 1

Ans:- Yes, sometimes it can be misleading to compare a company's financial ratios with those of the other firms that operate within the same industry. There can be many various reasons due to which financial ratios sometimes may appear misleading. Few of them are listed below.

(1) When the comparison is done within the same industry but with companies that have different business cycles. For example when the financial ratios are compared with a company that is in the growth stage with the company that is in the initial stage of its business then it can be misleading because the profit margins will be very different and that's, why financial ratios will not be the right, means to evaluate both the business.

(2) when the company is in the same industry but with very different sizes then the ratio comparison can be quite difficult because the operational values will be hugely different.

(3) when the ratios are compared between two companies that follow different accounting practices then it will not be right to judge the performances of the two companies with ratios.

(4) It is possible that some companies possess different strengths and weaknesses which may not reflect in financial ratios. Therefore in that scenario also evaluating performances only on the basis of financial ratios might be misleading because it may not show an actual comparison between the two companies.

Eg:- For example, if we take the company Amazon it is a global giant and is operated globally. Also, it has various sectors like retail, I.T, e-commerce, etc. if the financial ratios of amazon is compared with local e-commerce business like Flipkart which operates in India then the financial ratios might not show actual comparison because the size of business operation will be very different.

There are various other factors involved in evaluating the performances of the business within the same industry and the only financial ratio is not the tool to do so, therefore the financial ratios can be misleading sometimes.