7 limitations of ratio analysis

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  • 7 limitations of ratio analysis

    1. 1. Financial Statements Analysis Lecture 7 Limitations of ratio analysis &Problems with benchmarking
    2. 2. Lecture ObjectivesBy the end of this lecture you should be able to:I.Explain the level of analysisII.Explain the reasons for using ratios instead ofabsolute numbers for analysisIII.Discussthe various limitations of ratio analysisand its association with accounting qualityIV.Discussproblems with benchmarking forcross-sectional and time series analysis
    3. 3. I. Level of analysisa) 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
    4. 4. I. Level of analysisa) Industry analysis (cont’) o Analysis of the business and corporate strategy  Business strategy – products or services – type of customers – achieve competitive advantage  Corporate strategy – one business – multiple businesses
    5. 5. I. Level of analysisb) Accounting analysisi. Incentive to manage the annual accountsii. The available accounting discretioniii. Quality of disclosure
    6. 6. I. Level of analysisb) Accounting analysisi. Incentives to manage the annual accountsa) Incentives driven by contracts with regulatory authorities and governmentsb) Incentives driven by management compensationc) Incentives driven by the contract with the shareholdersd) Incentives driven by debt contracts
    7. 7. I. Level of analysis b) Accounting analysis i. Incentives to manage the annual accountsa. Contracts regulatory authorities & governments o Tax-biased accounting – minimize taxes o Avoid regulatory interventionb. Contracts with management compensation o Try to meet the bonus criteria o Try to have a favourable share price in the case of stock options o Avoid management turnover, perform above the industry-average o Earnings management around CEO-turnover – big bath accounting
    8. 8. I. Level of analysis b) Accounting analysisi. Incentives to manage the annual accounts (cont.)c. Incentives driven by the contract with the shareholders o Low earnings volatility – income smoothing o Recurrent and increasing stream of earnings o Meeting earnings targets and industry benchmarksd. Incentives driven by debt contractsoTry to avoid violation of debt covenantsoTry to get favourable credit ratings
    9. 9. I. Level of analysisb) Accounting analysisii. The available accounting discretion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)
    10. 10. Level of analysis b) Accounting analysisii.The available accounting discretion (cont.) Board characteristics ◦ Percentage of independent directors ◦ Presence of audit committee ◦ CEO duality Audit qualityiii. Quality of disclosure• Description of accounting methods and accounting estimates• Explanation of significant changes in accounting methods and accounting estimates• Level of information disclosure
    11. 11. iii. Quality of disclosure (cont’)Accounting method choice & estimatesChoice of depreciation methodChoice of inventory valuationChoice whether or not to capitalize certain expendituresChoice with regard to the valuation base (historical cost versus fair value)..Bad debt allowancesProvisionsWrite-down on inventoryImpairment of assetsUseful life or economic life of a fixed asset
    12. 12. II. Why use ratios instead of absolute values?Help to screen information in the financial statements rapidly and simplify crucial aspectsUseas inputs in decision making modelsControl for sizeControl for industry wide factors
    13. 13. III. Limitations of using ratiosa. Accounting policies & methods
    14. 14. III Limitations of using ratios (cont’)b. Difficulty to assess with industry norms and benchmarks - due to business diversification, difficult to compare like with likec. Timing in financial year end - differences hide normal business activity e.g. comparing year end December and Marchd. 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.
    15. 15. III Limitations of using ratios (cont’)d. Creative accounting (cont’) TECHNIQUES: •Sales related (creating bogus sales/invoice, bringing forward, etc) •Expense related (creating false expenses, over exaggerating expenses, etc) • Big bath/housekeeping • Cookie jar
    16. 16. III Limitations of using ratios (cont’)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
    17. 17. d. Creative accounting (cont’)Big bath/housekeepingExample: Actual t0 Adjusted t0 Forecasted t1Gross 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% worseIf report adjusted figure in t0, loss (25-20)/25 x 100 = 20% worse
    18. 18. d. Creative accounting (cont’)Cookie jar- making provisions when profits are high than expected and releasing them when times are difficultExample:Yr 1 Market expected company to make profit £150mYr 1 Actual profit 200 Provision (45) created provision Reported profit155Yr 2 Market expected company to make profit £170mYr 2 Actual profit 150 Provision 20 released provision Reported profit170
    19. 19. d. Creative accounting (cont’) Off balance-sheet financing A financing activity in which large capital expenditures are excluded from a companys 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 100 150 100 150 Debt 20 70 Equity 80 80 100 150 D/E 20/80= 25% 70/80= 87.5%
    20. 20. 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) Effectiveratio analysis must attempt to relate underlying business factors to the financial numbersHowever, benchmarking has its problems…….
    21. 21. IV. Ratio Analysis BenchmarkingProblems in Cross-sectional Analysis1. Data availabilitya) 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 periodc) non-uniformity in accounting methods - restrict sample to those using similar methods; adjust reported numbers or use approximation method
    22. 22. Problems in Cross-sectional Analysis (cont’)2. International comparisonsa) accounting principles - US doesn’t use IFRSb) taxation rules - in UK, different rules for tax and reporting while in France, Germany, same rules for tax and reportingc) Financing & operational arrangements - debt is more popular form in Germany, Japan, Korea but equity in the UK, USd) cultural, economic, political environment - law: common vs. codified law; type of ownership; govt.-buss. relations
    23. 23. Problems in Cross-sectional Analysis (cont’)3. Activity of firms- look at segmental reporta) acquisitions/diversification - new product line; geographic; create synergyb) divestitures/sell off - combine remaining divisions; discontinued; re- align continuing activitiesc) organisational changes - structural changes in divisions affect performanced) internal reporting system - how accounts are kept and reported e.g. allocation methods, transfer pricing
    24. 24. Problems in Cross-sectional Analysis (cont’)4. Industry comparisona) classification of industry - selecting comparables (see next slide)b) sources of info on industry - UK: SEIC (FTSE classification); US: SIC; analyst or ownc) industry differences - ratios affected by type of industry e.g. gearing high for airline but low for life insurance
    25. 25. 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
    26. 26. Problems in Time Series Analysis 1. Structural Issues 2. Accounting method changes & classification
    27. 27. Problems in time series – Structural issueWithin company1. Financing structure – e.g. change in composition of debt to equity2. Product mix – e.g. diversification; new product range3. Mergers – e.g. change in structure and businessOutside company1. Competition – e.g. contraction in mkt. share due to entrance of big player2. Technology - advancement in R & D/major discovery3. Economy - inflation & interest rate, economic cycle, etc4. Regulation - e.g. environmental Act
    28. 28. Problems in time series – Change inaccounting 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
    29. 29. Problems in time series – Change inaccounting methods & classificationINCOME SMOOTHINGWhat is it?- an exercise in the reduction of long-run earnings variabilityMotives 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

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