Question

A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a company’s strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a company’s performance to that of its competitors or to its past or expected future performance. Such insight helps managers and analysts improve their decision making.

Consider the following scenario:

You work as an analyst at a credit-rating agency, and you are comparing firms in the construction and engineering sector. One company in the portfolio of companies you are analyzing is a Chinese firm. This firm stands out in the ratio analysis, because the company’s financial ratios are substantially lower than identical financial ratios of the other firms in the sector. You do not dissect the results of the ratio analysis and report this firm as an under-performing company.

Which of the following statements about your analysis report is true?

The analysis likely includes incorrect and misleading conclusions.

The ratios provide an accurate and thorough representation of the Chinese company’s performance.

Answer 1

Your analysis is likely to include incorrect and misleading conclusions.

Ratios are calculated using a company’s balance sheet, income statement, and other financial statements. However, the ratios by themselves do not provide a full picture of a company’s performance; rather, they serve as indicators of certain aspects—such as strengths or weaknesses—of a company’s performance. As the analyst, you must accurately and appropriately see and describe the relationships between the source data, the ratio values, the decisions made by company management, and the firm’s activities.

It is important to understand the implied meaning of ratios by examining the situations that cause individual ratios to take on their observed values. What managerial decisions or business activities, or lack thereof, cause the ratios to exhibit their observed value? It is also important to understand that different accounting techniques lead to differences in the financial ratio results. The ratios for the Chinese firm could have been substantially different from those of their competitors due to the accounting techniques used by the company.

Because you did not dissect and adequately examine and interpret the financial ratios for the Chinese firm—and analyze the potential causes that could lead to substantial differences in its financial ratios compared with the ratios of other companies in the industry—your report likely includes incorrect conclusions.