Question

From the e-activity, determine why it is sometimes misleading to compare a company's financial ratios with those of other firms that operate within the same industy. Support your response with one (1) example form your reserach.

Use the Internet to research instances when a company’s financial ratios did not align with those of other firms that operate within the same industry. Be prepared to discuss.

Answer 1

It can sometimes be misleading to compare a company’s financial ratios with those of other firms that operate within the same industry. This may often happen when the size of the two companies are radically different from one another. When sizes of the companies are different then their liquidity position, solvency position, leverage position and activity position will not only be different but also not comparable. Secondly different companies in the same industry may be at different stages of their business. For instance the ratios of a business that is in its maturity stage will not be comparable with ratios of business that is in its growth stage. The company that is operating in the growth stage will generate lower free cash flows as its capital investment will be much higher. Also it will make use of more debt in its capital to finance its growing operations.

An instance when a company’s financial ratios did not align with those of other firms that operates within the same industry is that of Apple when it was in the growth stage after the launch of successful products like i-Pod, i-Pad and i-Phone. The company went into growth stage after these launches and hence compared to the industry average the company had lower asset turnover than the industry average (due to its high investments in fixed assets for the future) and higher debt ratios due to use of leverage to finance its growing operations.