7 limitations of ratio analysis

Financial Statements Analysis

Lecture 7

Limitations of ratio analysis&

Problems with benchmarking

Lecture Objectives

By the end of this lecture you should be able to:

I.Explain the level of analysis

II.Explain the reasons for using ratios instead of absolute numbers for analysis

III.Discuss the various limitations of ratio analysis and its association with accounting quality

IV.Discuss problems with benchmarking for cross-sectional and time series analysis

a) Industry analysis

Analysis of the business environment

– degree of competition

– price competition

– high or low barriers to entry

– the relation of the input and output

market of a firm

I. Level of analysis

a) Industry analysis (cont’)oAnalysis of the business and corporate

strategy Business strategy

– products or services

– type of customers

– achieve competitive advantage

Corporate strategy

– one business

– multiple businesses


b) Accounting analysis

i. Incentive to manage the annual

accounts

ii. The available accounting discretion

iii. Quality of disclosure


i. Incentives to manage the annual i. Incentives to manage the annual accountsaccounts

a) Incentives driven by contracts with regulatory

authorities and governments

b) Incentives driven by management compensation

c) Incentives driven by the contract with the

shareholders

d) Incentives driven by debt contracts



a. Contracts regulatory authorities & a. Contracts regulatory authorities & governmentsgovernments


o Tax-biased accounting – minimize taxeso Avoid regulatory intervention

b. Contracts with management b. Contracts with management compensationcompensationo Try to meet the bonus criteriao Try to have a favourable share price in the

case of stock optionso Avoid management turnover, perform

above the industry-averageo Earnings management around CEO-

turnover – big bath accounting

i. Incentives to manage the annual i. Incentives to manage the annual accountsaccounts


c. Incentives driven by the contract c. Incentives driven by the contract with the shareholderswith the shareholders


o Low earnings volatility – income smoothingo Recurrent and increasing stream of earningso Meeting earnings targets and industry

benchmarks

d. Incentives driven by debt d. Incentives driven by debt contractscontractsoTry to avoid violation of debt covenantsoTry to get favourable credit ratings

i. Incentives to manage the annual i. Incentives to manage the annual accounts (cont.)accounts (cont.)


ii. The available accounting ii. The available accounting discretiondiscretion


Impact of the quality of accounting standards used◦ High quality versus low quality accounting

standards, low quality standards allow more flexibility

Institutional characteristics◦ Risk of litigation, degree of enforcement

Company characteristics◦ Ownership structure (dispersed vs

concentrated; listed vs nonlisted)


ii. The available accounting ii. The available accounting discretion (cont.)discretion (cont.)

Level of analysis

Board characteristics◦ Percentage of independent directors◦ Presence of audit committee◦ CEO duality

Audit quality

iii. Quality of disclosureiii. Quality of disclosure

• Description of accounting methods and accounting

estimates

• Explanation of significant changes in accounting

methods and accounting estimates

• Level of information disclosure


Accounting method choice & Accounting method choice & estimatesestimatesChoice of depreciation methodChoice of inventory valuationChoice whether or not to capitalize certain

expendituresChoice with regard to the valuation base

(historical cost versus fair value)..Bad debt allowancesProvisionsWrite-down on inventoryImpairment of assetsUseful life or economic life of a fixed asset

iii. Quality of disclosure (cont’)iii. Quality of disclosure (cont’)

II. Why use ratios instead of absolute values?

Help to screen information in the financial statements rapidly and simplify crucial aspects

Use as inputs in decision making models

Control for size

Control for industry wide factors

III. Limitations of using ratios

a. Accounting policies & methods

III Limitations of using ratios (cont’)

b. Difficulty to assess with industry norms and benchmarks

- due to business diversification, difficult to compare like with like

c. Timing in financial year end

- differences hide normal business activity e.g. comparing year end December and March

d. Creative accounting

- earnings management where accounting practices may follow the letter of the rules of accounting standards but certainly deviate from the spirit of those standards. It is exercised through excessive and complicated use of revenue, assets and liabilities for the intent to influence readers of the financial statements.

TECHNIQUES:

•Sales related (creating bogus sales/invoice, bringing forward, etc)

•Expense related (creating false expenses, over exaggerating expenses, etc)

• Big bath/housekeeping

• Cookie jar

d. Creative accounting (cont’)


Taking a one-time loss through a major cleaning-up exercise (‘big bath’) of the balance sheet◦an exceptional one-time operation

◦through front-loading of costs



Big bath/housekeeping Example:

Actual t0 Adjusted t0 Forecasted t1

Gross profit 80 80 65-Expenses (60) (75) (60) EBIT 20 5 5-Interest (25) (25) (30) EBT (5) (20) (25)-Tax - - - Loss (5) (20) (25)

Note:

If report actual figure in t0, loss (25-5)/25 x 100 = 80% worse

If report adjusted figure in t0, loss (25-20)/25 x 100 = 20% worse


Cookie jar - making provisions when profits are high than expected and releasing them when times are difficult

Example:

Yr 1 Market expected company to make profit £150m

Yr 1 Actual profit 200 Provision (45) created provision Reported profit155

Yr 2 Market expected company to make profit £170m Yr 2 Actual profit 150 Provision 20 released provision Reported profit170


Off balance-sheet financing

A financing activity in which large capital expenditures are excluded

from a company's financial position through various classification

methods in order to keep the debt to equity (D/E) ratio low and

maintain debt covenant.

Off balance sheet , e.g. 5 aircrafts worth 50m leased for their economic life.

Excluded Included£m £m

Assets 100 150100 150

Debt 20 70Equity 80 80

100 150D/E 20/80= 25% 70/80= 87.5%


IV. Ratio Analysis Benchmarking

Evaluating ratios requires comparison against some benchmark.

Such benchmarks include:

◦ Ratios of other firms in the industry

(cross-sectional)◦ Ratios over time from prior periods

(time series)

Effective ratio analysis must attempt to relate underlying business factors to the financial numbers

However, benchmarking has its problems…….

Problems in Cross-sectional Analysis

1. Data availability

a) non-availability - due to ltd. disclosure, foreign language or

private co.?

b) non-synchronous reporting periods - due to difference in yr-end e.g. US in Dec;

Japan in March; Australia in June. Hence, need to adjust the reporting period

c) non-uniformity in accounting methods

- restrict sample to those using similar methods; adjust reported numbers or use approximation method

IV. Ratio Analysis Benchmarking

2. International comparisons

a) accounting principles

- US doesn’t use IFRS

b) taxation rules

- in UK, different rules for tax and reporting while in France, Germany, same rules for tax and reporting

c) Financing & operational arrangements

- debt is more popular form in Germany, Japan, Korea but equity in the UK, US

d) cultural, economic, political environment

- law: common vs. codified law; type of ownership; govt.-buss. relations

Problems in Cross-sectional Analysis (cont’)

3. Activity of firms- look at segmental reporta) acquisitions/diversification

- new product line; geographic; create synergy

b) divestitures/sell off

- combine remaining divisions; discontinued; re-align continuing activities

c) organisational changes

- structural changes in divisions affect performance

d) internal reporting system

- how accounts are kept and reported e.g. allocation methods, transfer pricing


4. Industry comparison

a) classification of industry

- selecting comparables (see next slide)

b) sources of info on industry

- UK: SEIC (FTSE classification); US: SIC; analyst or own

c) industry differences

- ratios affected by type of industry e.g. gearing high for airline but low for life insurance


Selecting Comparables in Cross-sectional Analysis

similarity on supply side (industry level)

- use same raw materials, production process, distribution networks

similarity on demand side (product level)

- similar end-product (substitute); similar brands & range of products

similarity in capital market attributes

- for investment purposes: e.g. similar risk factor, listed in same market

similarity in legal ownership

- public listed companies, private companies

1. Structural Issues

2. Accounting method changes & classification

Problems in Time Series Analysis

Problems in time series – Structural issue

Within company

1. Financing structure – e.g. change in composition of debt to equity

2. Product mix – e.g. diversification; new product range

3. Mergers – e.g. change in structure and business

Outside company1. Competition – e.g. contraction in mkt. share due to

entrance of big player

2. Technology - advancement in R & D/major discovery

3. Economy - inflation & interest rate, economic cycle, etc

4. Regulation - e.g. environmental Act

Problems in time series – Change in accounting methods & classification

a) Mandatory vs. Voluntary- change in regulation or company’s policy

affects disclosure

b) Accounting policy choice - principles-based vs rule-based

c) Timing of event

- change in year-end or recognition of events

INCOME SMOOTHING

What is it?- an exercise in the reduction of long-run earnings

variability

Motives for income smoothing

- promote an external perception that company is low risk

- minimize tax

- promote an external perception of competent mgmt.

- increase compensation paid to mgmt.

- maintain satisfactory industrial relations

- convey information relevant to the prediction of future

earnings

Problems in time series – Change in accounting methods & classification