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1. Why use care with Financial Statement Analysis?
2. Caution with Ratio Analysis.
1. WHY USE CARE WITH FINANCIAL STATEMENT ANALYSIS?
The basic problems with financial statement analysis is that there is
no underlying theory to help us identify which items or ratios to look
at and to guide us establishing a benchmark.
One particularly severe problem is that many firms are conglomerates,
owning more or less unrelated lines of business. The consolidated
financial statements of such firms don?t really fit any neat industry
category. For example, Sears has an SIC code of 6710 (Holding Offices)
because of its diverse financial and retailing operations. More
generally, the kind of peer group analysis we describe is going to
work best when the firms are strictly in the same line of business,
the industry is competitive, and there is only one way of operating.
Another problem that is becoming increasingly common is that major
competitors and natural peer group members in an industry may be
scattered around the globe. The automobile industry is an obvious
example. The problem here is that financial statements from outside
the United States do not necessarily confirm at all to GAAP (more
precisely, different countries can have different GAAPs). The
existence of different standards and procedures makes it very
difficult to compare financial statements across national borders.
Even companies that are clearly in the same line of business may not
be compatible. For example, electric utilities engaged primarily in
power generation are classified in the same group (SIC 4911). The
group is often thought to be relatively homogeneous. However,
utilities generally operate as regulated monopolies, so they don?t
compete with each other. Many have stockholders, and many are
organized as cooperatives with no stockholders. There are several
different ways of generating power, ranging from hydroelectric to
nuclear, so the operating activities can differ quite a bit. Finally,
profitability is strongly affected by regulatory environment, so
utilities in different locations can be very similar but show very
Several other problems frequently crop up. First, different firms use
different accounting procedures?for inventory, for example. This makes
it difficult to compare statements. Second, different firms end their
fiscal years at different times. Form firms in seasonal businesses
(such as a retailer with a large Christmas season), this can lead to
difficulties in comparing balance sheets because of fluctuations in
accounts during the year. Finally, for any particular firm, unusual or
transient events, such as one-time profit from an asset sale, may
affect financial performance. In comparing firms, such events can give
Source: Ross, Westerfield, Jordan, Essentials of Corporate Finance.
New York: Mc Graw Hill, 2003
2. CAUTION WITH RATIO ANALYSIS
From the pages of Ferris State Univ.- Prof. Sid Sytsma
?Many times, however, ratios are used in a harmful manner. Some
corporate managers look at ratios for their company and, for example,
industry averages. They then assert that because a particular ratio
for their company is different from the analog for the industry that
there is some problem with the company. Nothing could be further from
the truth.? The company could conceivably be outperforming the
industry. Ratio differences could describe strength. Interpretation of
ratios therefore is critical.
From the pages of Business Link Organization
?A word of caution, an individual ratio calculation should be tempered
by taking into account other ratio analyses which results in a more
effective evaluation of the financial operations of the business.
Similarity, using industry averages as a comparative tool can also
lead to inappropriate assumptions, as these industry averages may be
based in dissimilar accounting policies and practices. Therefore, it
is imperative that calculation of these industry averages be fully
understood before using them as a comparative tool.?
From the page of Staffordshire University
?Ratio Analysis is all about comparing one set of ratios with another.
This can mean comparing one year with another, or comparing the
performance of one company with another or with its budgets.
To achieve greater confidence in the conclusions you draw, you really
need to compare more values than just two. You also need to bear in
mind that there is some flexibility in the accounting treatments
adopted by accountants when preparing the financial statements and so
differences observed in performance might in part be due to
differences in the way items have been treated in the accounts rather
than differences in performance.?
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I hope this helps. Please clarify, if you are not satisfied with the answer.