106 Part 2 Fundamental Concepts in Financial Management
4-12 USES AND LIMITATIONS OF RATIOS
As noted earlier, ratio analysis is used by three main groups: (1) managers, who use
ratios to help analyze, control, and thus improve their! rms’ operations; (2) credit
analysts, including bank loan of! cers and bond rating analysts, who analyze ratios
to help judge a company’s ability to repay its debts; and (3) stock analysts, who are
interested in a company’s ef! ciency, risk, and growth prospects. In later chapters,
we will look more closely at the basic factors that underlie each ratio. Note, though,
that while ratio analysis can provide useful information concerning a company’s
operations and! nancial condition, it does have limitations. Some potential prob-
lems are listed here:- Many! rms have divisions that operate in different industries; and for such
companies, it is dif! cult to develop a meaningful set of industry averages.
Therefore, ratio analysis is more useful for narrowly focused! rms than for
multidivisional ones. - Most! rms want to be better than average, so merely attaining average perfor-
mance is not necessarily good. As a target for high-level performance, it is best
to focus on the industry leaders’ ratios. Benchmarking helps in this regard. - In" ation has distorted many! rms’ balance sheets—book values are often dif-
ferent from market values. Market values would be more appropriate for most
purposes, but we cannot generally get market value! gures because assets
Enron’s decline spurred a renewed interest in! nancial
accounting, and analysts now scour companies’! nancial
statements to see if trouble is lurking. This renewed interest
has led to a list of red # ags to consider when reviewing a
company’s! nancial statements. For example, after confer-
ring with New York University Accounting Professor Baruch
Lev, Fortune magazine’s Shawn Tully identi! ed the following
warning signs:- Year after year a company reports restructuring charges
and/or write-downs. This practice raises concerns be-
cause companies can use write-downs to mask operat-
ing expenses, which results in overstated earnings. - A company’s earnings have been propped up through a
series of acquisitions. Acquisitions can increase earnings
if the acquiring company has a higher P/E than the ac-
quired! rm, but such “growth” cannot be sustained over
the long run. - A company depreciates its assets more slowly than the
industry average. Lower depreciation boosts current
earnings, but again this cannot be sustained because
eventually depreciation must be recognized. - A company routinely has high earnings but low cash
ow. As Tully points out, this warning sign would have
exposed Enron’s problems. In the second quarter of
2001 (a few months before its problems began to un-
fold), Enron reported earnings of $423 million versus a
cash # ow of minus $527 million.
Along similar lines, after consulting with various profession-
als, Ellen Simon of the Newark Star Ledger came up with her
list of red # ags:- You wouldn’t buy the stock at today’s price.
- You don’t really understand the company’s! nancial
statements. - The company is in a business that lends itself to “creative
accounting.” - The company keeps taking nonrecurring charges.
- Accounts receivable and inventory are increasing faster
than sales revenues. - The company’s insiders are selling their stock.
- The company is making aggressive acquisitions, espe-
cially in unrelated! elds.
There is some overlap between these two lists. Also, none of
these items automatically means there is something wrong
with the company—instead, the items should be viewed as
warning signs that cause you to take a closer look at the
company’s performance before making an investment.
LOOKING FOR WARNING SIGNS WITHIN THE FINANCIAL STATEMENTS
To find information about
a company quickly, link
to http://www.reuters.com. Here
you can find company
profiles and snapshots,
stock price quotes and share
information, key ratios, and
comparative ratios.