5.

3 CAUTIONS ABOUT USING RATIOS

Although ratios can be a powerful tool, it is important to be very cautious when using them. Differences
in accounting methods and estimates, as well as the existence of nonrecurring items, can cause ratio
differences. Differences across industries and business environment changes can make interpreting
ratios complicated. In addition, different disclosure levels across firms may make it impossible to
calculate certain ratios for certain firms. Finally, analysts define ratios in various ways. Valuable ratio
analysis requires the analyst to consider how a ratio was defined before interpreting its meaning.

Accounting Methods, Estimates, and Disclosures

An accounting analysis may uncover differences in accounting methods across firms or changes for a
given firm. As a result, we may need to adjust the financial statement data to make ratios more
meaningful or comparable in a trend analysis or a cross-sectional analysis. Also, we must consider how
management estimates affect ratios. These issues can be especially important if we are comparing ratios
of different companies.

Because we often calculate ratios to help us project the future, we may need to make adjust- ments for
items that will not continue into the future, being careful to identify what will and will not be recurring.
For example, we often remove nonrecurring items such as extraordinary items from the income
statement before calculating ratios involving net income.

In doing ratio analysis, we must recognize that different firms provide different levels of disclo- sure. For
example, some firms supply significantly more detail about cach business segment than is required,
whereas others give only the bare minimum. In each case, we will combine the available financial
information with the results of our business analysis to understand the firm. In many situ- ations,
computing ratios on more detailed segment data will produce better information. For exam- ple, by
looking at revenue and operating margin trends in each segment, we can identify which seg- ments are
growing and profitable.

Industry and Business Differences

We must also carefully consider information about the firm's business, industry, and economic con-
ditions as we analyze the meaning of the computed ratios. Ratios often vary substantially across
industries, so comparisons across companies are usually done within an industry. Even within an
industry, some firms are not comparable. Industry definitions can be rather general. For example,
Starbucks is sometimes categorized in the restaurant industry. IHOP Corporation (International House of
Pancakes), McDonald's Corporation, and Krispy Kreme Doughnuts, Inc. are also in this industry.
Starbucks' unique business characteristics make it not comparable to these firms. It is extremely
important to understand fully the business operations to determine when a competitive or industry
comparison is meaningful.

Business Environment Changes

Once we decide on comparable companies, it is vital to consider the business and environmental
changes that have occurred since the historical periods under study. While analyzing historical results,
we have to remember that history does not necessarily repeat itself and ask what might change in the
future. This requires understanding not only the financial statement analysis but also the changing
environment of the business. The business analysis should provide clues about the potential changes in
the business environment. For example, in the 1990s, the many start-up Internet companies created
demand for Internet infrastructure products and services from technol- ogy companies such as Lucent
Technologies and Cisco Systems. These infrastructure firms in turn experienced tremendous growth.
However, when the growth of Internet firms subsided-and many even went out of business-Lucent,
Cisco, and other firms also encountered a change in their busi- nesses, which caused the growth patterns
to change.

Ratio Definitions

If we use ratios prepared by others, it is important to keep in mind that analysts define ratios differ-
ently. For example, return on capital is income divided by capital, but income may be defined in many
ways, such as operating income, income before tax, and net income. Total capital may or may not include
minority interests. An analyst might use total capital as of the beginning of the period or an average
balance, which could be computed using either annual balances or quarterly balances.