Determine why it is sometimes misleading to compare a company’s financial ratios with those of other firms that operate within the same industry. Support your response with an example from your research.
FROM PROFESSOR:
According to your text, the short and sweet answer for discussion is that there is no single correct value for any ratio. When looking at financial ratios we have to consider the specifics of the ratio. To be more specific which ratio are we looking at and what financial statement do we pull those numbers from. When comparing financial ratios, we do not have the entire statement right in front of us so there are factors that may have occurred for one company (Pepsi) that may not have occurred for the next company (Coca-Cola) which are what Higgins, Koski, & Mitton (2019) call company-specific differences.
We could also see that Pepsi is operating in the red but it could be due to the fact they paid off some loans and now they do not have FCF (free cash flow) or a high amount of profits to show. However, as they continue to make sales and gain cash that is one less expense as well as the interest they no longer have to worry about. Whereas Coca-Cola may still be facing long-term debt and interest payments. The other factor that has to be taken into account is the method of accounting that is being used for the company. Different accounting and inventory methods can show different results at times. The main thing is that the industry as a whole may be doing bad (Higgins, Koski, & Mitton, 2019). If that is the case, would it even be worth comparing the competition’s ratios? Think about it, each business could have different sizes, target markets, pricing strategies, investment needs, and be in different stages of development.
I like to put things in a real-world perspective to make sure everyone can relate or understands what is going on. At this point of your educational journey, you have student loans or knows someone that does. So, let’s think about purchasing a house or something major. The first thing that is looked at by the lending institution is your credit score. But even with a good credit score, your debt-to-income ratio has to be good as well. If you have a lot of debt and not enough income coming in to cover that debt then the lending institution will not approve the loan. Check out the article below for a good read and some information to think about when buying a house after getting student loans.
Now let’s go back to businesses and managerial finance. One thing that we see a lot of in businesses is money laundering. When you think about it from a ratio perspective, it is revenues vs cost. How much control do banks have over this? Here is another great read.
These articles are kind of recent but since these articles we have experienced COVID-19. What if anything has changed since then that can affect credit scores, the way that companies report, and ratios over all?
Reference: Higgins, R. C., Koski, J. L., & Mitton, T. (2019). Analysis for financial management (12th ed.). New York, NY: McGraw-Hill Education.
~Dr. Inez Black
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