Question

Enhanced understanding financial ratios results from using and interpreting the ratios, not from memorizing them. It cannot be emphasized enough as to how important the interpretation of financial statement ratios are. This is a necessarily qualitative and intellectual process, which requires the analyst to have understood the firm's specific strategy in the context of the industry and to be aware of any underlying accounting choices that affect the data used in the computation of the financial ratios being examined.

There are alternative methods for examining profitability. Simple approaches, such as earnings-per-share, common-size, and percentage change analysis, as well as subjective redefinition of profits. However, the how to interpret different levels of the key profitability proceeds through four levels of depth. Level 1 involves measures of profitability for a firm as a whole: the rate of ROA and the rate of ROCE. Level 2 disaggregates ROA and ROCE into important components. ROA disaggregates into profit margin for ROA and assets turnover. ROCE disaggregates into profit margin for ROCE, assets turnover, and capital structure leverage components. Level 3 disaggregates the profit margin into various expense-to-sales percentages and disaggregates assets turnover into individual asset turnovers. Level 4 uses product and geographic segment data to study ROA, profit margin, and assets turnover more fully.

Analyzing financial statement ratios is the forensic part of the process of investigating. In this step, the analyst must dig deep to understand why ratios are what they are. How do the ratios reflect the economics of the industry and the specific strategy of the firm? Do the ratios suggest that a firm is performing better or worse compared to its peers or is performing better or worse through time? Are there accounting choices that hinder the ability to productively use ratios to better understand the firm?

Required:

Discuss what questions and considerations should analysts raise when comparing financial ratios to:

Earlier Periods?

Other Firms?

Answer 1

Comparing financial ratios to earlier periods: When analysts are comparing current financial ratios of a firm to earlier periods they should raise questions with regards to the comparability of the current period with that of the earlier period. For instance during the initial years of a company (when it was started) the company would focus more on acquiring new customers and expanding its market. Thus the amount of SG&A (selling, general and administrative expenses), marketing expenses and capital expenditures are high during the initial years (as a percentage of sales). Once the company stabilizes its expenses as a percentage of sales will decline (or will stop growing). Thus the company’s profitability ratios will not be reasonably comparable. In the initial years the company’s profitability ratios like return on assets, return on equity, earning power etc. will be lower compared to its later years.

Also analysts should raise questions with regards to economic scenario of earlier periods and compare it with the economic scenario of current period. It may just happen that the economic scenarios of the earlier periods were not the same as the economic scenario of the current period. The current scenario may be in the grip of a recession and hence comparing ratios will not yield meaningful analysis.

Comparing financial ratios to other firms: Different firms have different business models and hence their financial ratios will also differ. This holds especially true for companies that operate in different industries. For instance a company that operates a chain of hotels or a capital goods company will have higher component of debt in its books when compared to a service company like McKinsey. Thus the debt/equity ratio or the debt/asset ratio will not be comparable. In such cases the analysts will have to consider the nature of business, the business model and the requirements of the industry before analyzing the ratios of two different firms.