(a) Comparisons
Accounting ratios can be used to assess the strength and performance of a company. They are mainly used to compare a company's performance over time or to compare one company with another (or to the average for similar companies).
Accounting ratios are calculated from published financial statements, and so they are subject to the
same estimates and judgements as the statements. Accounting ratios tend to raise questions rather than answer them; for example a declining gross profit margin might indicate increased input costs or a declining sales price. Because of this, ratio analysis is often used in practice to identify areas that need further investigation.
More problems arise when companies are being compared, as it is difficult to find two companies that really are comparable:
Big, publicly quoted companies often have diverse business interests located around the globe,
unlike their smaller rivals which are more localised and less diversified.
Different accounting policies can affect key ratios.
Different business practices may affect reported profits and assets. For example a business
operating from rented premises and using rented equipment will have a very low capital
employed compared with a similar business that owns its own premises and equipment.
Financial position values may not be typical for the year as a whole. This might be because of
seasonal fluctuations (for example a farming business) or because of a deliberate attempt to
tidy up the statement of financial position for the year-end by collecting in receivables and
delaying the payment of suppliers.
The dividend policy of a publicly quoted company will be very different from that of a small
family company.
Big companies tend to have different economies of scale than smaller companies.
The use of a comparison service will exaggerate these problems:
Users will not know which firms have been used in the comparison. Because companies
themselves are diverse, averages calculated may not be comparable to the user's company.
For example, a small brewery may be focused on its core activity of brewing beer, but its
competitor companies used by the comparison service may have diversified into hotels,
retailing and other leisure activities.
The year-ends of companies used will affect the ratios calculated.
Averaged information will not tell you what the typical (modal) ratio is, nor will it tell you what
the normal range of ratios is.
Overall, although it is a useful and informative exercise to compare ratios, care must be taken to
ensure that like is being compared with like. |
