Question

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

Answer 1

It is misleading to compare the financial ratio of a company with those of other companies that operate within the same industry because-

A. Different capital structure which will be present in order to generate rate of return for both these companies

B. There will be different level of risk which has been undertaken by both the company in order to generate the rate of return so they are not directly comparable.

C. There are various quality factors like the reputation of the board and the trustworthiness of the company which cannot be compared.

D. Various risk related to survival of the company in the long run and other futuristic factors are not discounted in the books of accounts so it is not directly compared.

E. There will be different types of project which are undertaken by these companies and they can have different cash flow streams so this company are not directly comparable because they can be profitable at different times

F. There will be various types of legal issues and litigation issues which are not directly discounted into the books of accounts and these have to be taken into perspective before comparison

Hence it can be said that the books of accounts are not representation of the financial state of the company and it can relate to other qualitative factors and books of accounts can also be manipulated so it is not rational to compare.