The Foundation
3.8 Limitations of Financial Ratio Analysis
While financial ratios clearly provide important information about a firm’s health and profit- ability, such analysis has several limitations including:
• identifying appropriate industry averages for comparison purposes;
• adjusting for the effects of inflation on financial statements;
• adjusting for the effects of different accounting practices on financial statements and ratios; and
• drawing conclusions about a ratio for a particular firm.
As we discussed earlier in the chapter, analysts should examine a firm’s performance within the context of its industry environment. That is, the financial ratios for a firm should be com- pared to either industry average ratios or to relevant competitors. Several issues arise that complicate these comparisons. Many firms are widely diversified across various industry segments. While the firm’s Standard Industrial Classification (SIC) Code may place it in a particular industry segment, the firm’s assets and operations within its other divisions may affect its financial statements and ratios. Other firms within the same major industry segment may also be widely diversified into other industry sectors that are different from the firm.
The question also arises as to whether to use an industry average. The industry average consists of firms in a particular industry segment, both the good and the poor performers.
Comparing a leading firm within an industry to the industry average may be inappropriate.
A better approach might be to compute a new industry average that leaves out the weak
performers or to simply compare the ratios of the firm to those of two or three of its closest competitors.
Answers to these questions require judgment on the part of the analyst. In this chapter, comparing financial ratios of Home Depot to industry averages may be inappropriate because Home Depot is by far the largest firm in the retail building supply industry. Instead, we chose to compare Home Depot to Lowe’s, its closest competitor. Was this the right choice? Arguments can be made for and against such an approach but we discussed our reasons for doing so. Other qualified analysts might have used different logic and chosen a different approach.
Finally, when using financial ratios for making comparisons, analysts should check to make sure that all ratios are computed using the same formula. Different financial services sometimes use slightly different formulas for some of the ratios. We have pointed out some of these differences in this chapter.
Financial analysts also need to consider the effects that inflation has on a firm’s financial statements. Since many assets are recorded on an historic cost basis, inflation may cause some of these reported values to be understated. This is especially true for fixed assets, particularly when substantial property is included. Understating fixed assets causes biases in ratios using total assets or fixed assets. Furthermore, comparison between competitors or industry averages becomes complicated when different firms within the industry have varying degrees of distortion due to the effects of inflation on their fixed assets. Some firms may be carrying fixed assets on their balance sheets that are much older than other firms that have modernized and have newer plant and equipment. Analysts need to take into account these differences when making comparisons.
Concept Check 3.8
1 What are several important limitations of financial ratio analysis? How can these limitations be overcome?
Summary
This chapter discussed how to interpret financial ratios. The major points follow.
1 Financial ratios help users of financial statements to more carefully assess a firm’s financial condition.
2 Five major categories of ratios are: liquidity, debt management, asset management, profitability, and market value.
3 Liquidity ratios indicate a firm’s ability to pay its bills in the short run.
4 Debt management ratios characterize a firm in terms of the relative mix of debt- equity financing and measure the long-term debt paying ability of a firm.
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5 Asset management ratios measure the ability of a firm’s management to manage the assets at its disposal.
6 Profitability ratios measure the ability of a firm’s management to generate profits.
7 Market value ratios provide information about a firm’s relative market value.
FURTHERREADING
Beaver, William H. Financial Reporting: An Accounting Revolution, Prentice-Hall, 1989.
Bernstein, Leopold A. and John J. Wild. Financial Statement Analysis: Theory, Application, and Interpreta- tion, 6th edn, Irwin McGraw Hill, 1998.
Choi, Frederick D. S., Carol Ann Frost, and Gary Meek. International Accounting, Prentice-Hall, 2000.
Stickney, Clyde and Paul R. Brown. Financial Reporting and Statement Analysis: A Strategic Perspective, 4th edn, Dryden Press, 1999.
White, Gerald I., Ashwinpaul C. Sondhi, and Dov Fried. The Analysis and Use of Financial Statements, 3rd edn, Wiley, 2003.
Chapter 4
The Time Value of Money
I will gladly pay you Tuesday for a hamburger I can eat today. (Wimpie, from the Popeye cartoon, E. C. Segar.)
Overview
Money has time value. We know this intuitively because most of us would prefer to receive $1,000 today than 1 year or 5 years from today. By receiving it today, we can invest the money and expect to have an even greater sum in the future. The same reasoning suggests we, not unlike Wimpie, should prefer to pay money we owe later than sooner. Thus, the value of money depends on the time when it is paid or received.
Many important financial decisions of a firm involve cash flows at various points in time. Financial managers should consider how time affects the value of these cash flows. For example, when a firm issues bonds to investors, managers should compare the value of future cash payments owed to the bondholders in exchange for the cash received today. Similarly, when making capital investments, managers need to com- pare the value of expected cash flows in the future to the present cash outlay needed to undertake the investment. In both cases, financial managers must understand how the value of cash flows varies at different points in time.
This chapter deals with the mathematics of the time value of money. Specifically, we provide the mathematical relationships for determining the future value of a present cash amount and the present value of a specified future cash amount. These future and present value relationships are extended to incorporate multiple cash flows that are equal and periodic (annuities) and multiple cash flows that are not. We also show how to determine the implied interest rate.
Learning Objectives
After completing this chapter, you should be able to:
• explain the meaning of the time value of money and the importance of the timing of cash flows in making financial decisions;
• calculate the future value and present value of cash flows for one period and multiple periods;
• solve for the interest rate implied by a given set of present value and future value cash flows;
• apply time value of money techniques to solve basic problems facing financial managers;
• use a financial calculator to solve time value of money problems.
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