Ratios in General

Question 1

How is the development of ratios for comparison with industry averages useful?

Answer 1

Development of ratios for comparison with industry averages is more useful for firms that operate within a particular industry than for conglomerates (firms that operate in a variety of industries)

FASB issued Statement No. 14 (which was later amended) that required companies to provide segment information. Analyst can no determine whether a company’s overall ratios are comparable to any of the industries in which the company operates

For comparison purpose, industry averages can be obtained from industry journals (i.e. Robert Morris Associates and Standard & Poor’s)

Question 2

What are some inherent limitations of ratio analysis?

Answer 2

Inherent limitations of ratio analysis consist of the following:

1. Effects of inflation
2. Seasonal factors
3. Window dressing financials
4. Accounting policies
5. Accounting estimates

Note: There are other factors as well

Question 3

How does the effect of inflation affect ratio analysis?(Inherent limitations of ratio analysis)

Answer 3

The effects of inflation on fixed assets & depreciation, inventory costs, long-term debt and profitability cause misstatement of a firm’s balance sheet and income statement (i.e. fixed assets and depreciation will be understated and inventory will be understated if LIFO is used)

Moreover, the interest rate increases that accompany inflation will decrease the value of outstanding long-term debt

Many assets are recorded at historical cost, so their fair value may not be reflected on the balance sheet

Question 4

How does seasonal factors affect ratio analysis?(Inherent limitations of ratio analysis)

Answer 4

Ratio analysis may be affected by seasonal factors (i.e. inventory and receivables may vary widely and year-end balances may not reflect the averages for the period)

Question 5

How does “window dressing” financial statements affect ratio analysis?(Inherent limitations of ratio analysis)

Answer 5

A firm’s management has an incentive to window dress financial statements to improve results (i.e. if the current or quick ratio is greater than 1.0, paying liabilities on the last day of the year will increase the ratio)

Question 6

How can accounting policies selected affect ratio analysis?(Inherent limitations of ratio analysis)

Answer 6

Comparability of financial statement amounts and the ratios derived from them is impaired if different firms choose different accounting policies

Also, changes in a firm’s own accounting policies may create some distortion in the comparison of results over a period of years

Question 7

How can accounting estimates affect ratio analysis?(Inherent limitations of ratio analysis)

Answer 7

Ratios are constructed from accounting data, much of which is subject to estimation Accounting profit differs from economic profit - the excess of revenues over the costs of land, labor and capital. Accountants, however, do not subtract the cost of investors’ capital

Question 8

Why would managers manipulate accounting data as a means to enhance stock prices?(Inherent limitations of ratio analysis)

Answer 8

Studies have found a relationship between accounting data and stock prices. Thus, managers may be induced to manipulate accounting data as a means of enhancing stock prices

One reason for manipulation is the observed tendency of the stock price of a public company to continue to move upward or downward for months after an earnings announcement, depending on whether the report was favorable or unfavorable, respectively

The ability of unscrupulous managers to deceive the market is supported by evidence that investors may be able to beat the market by purchasing shares of companies with high ratios of net operating cash flows to net income

Question 9

What are other inherent limitations of ratio analysis?

Answer 9

The following are other inherent limitations of ratio analysis?

1. Generalizations regarding which ratios are strong indicators of a firm’s financial position may change from industry to industry, firm to firm and division to division
2. Ratio analysis may be distorted by failing to use an average or weighted average
3. Misleading conclusions may result if improper comparisons are selected
4. Different ratios may yield opposite conclusions about a firm’s financial health, thus the net effects of a set of ratios should be analyzed

Question 10

What is Earnings quality?

Answer 10

Earnings quality is a measure of how useful reported earnings are as a performance indicator. It is the inverse of the variance earnings. If earnings have a high degree of variability, many ratios will become less meaningful

Consistency of earnings is an aspect of quality. A company that has widely varying earnings levels from year to year will be said to have a low level of earnings quality because looking at a single year’s earnings will not really tell you anything about the long-term aspects of the company

Analysts also look at a company’s accounting policies when assessing earnings quality (i.e. during a period of inflation, a company using LIFO will be said to have a higher level of earnings quality than would a company with FIFO because LIFO presents more conservative numbers on both the income statement and balance sheet