This document discusses limitations of ratio analysis and problems with benchmarking ratios. It explains that ratios are used instead of absolute numbers to simplify analysis and control for factors like company size. However, ratios have limitations due to accounting policies, difficulty assessing industry norms, and creative accounting techniques used to manage earnings. Benchmarking ratios against peers or over time also has problems due to non-comparable data, structural changes in companies, and changes in accounting methods.

1. Financial Statements Analysis
Lecture 7
Limitations of ratio analysis
&
Problems with benchmarking

2. 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.Discussthe various limitations of ratio analysis
and its association with accounting quality
IV.Discussproblems with benchmarking for
cross-sectional and time series analysis

3. I. Level of 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

4. I. Level of analysis
a) 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. I. Level of analysis
b) Accounting analysis
i. Incentive to manage the annual accounts
ii. The available accounting discretion
iii. Quality of disclosure

6. I. Level of analysis
b) Accounting analysis
i. Incentives to manage the annual accounts
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

7. I. Level of analysis
b) Accounting analysis
i. Incentives to manage the annual accounts
a. Contracts regulatory authorities & governments
o Tax-biased accounting – minimize taxes
o Avoid regulatory intervention
b. 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. I. Level of analysis
b) Accounting analysis
i. 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 benchmarks
d. Incentives driven by debt contracts
oTry to avoid violation of debt covenants
oTry to get favourable credit ratings

9. I. Level of analysis
b) Accounting analysis
ii. 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. Level of analysis
b) Accounting analysis
ii.The available accounting discretion (cont.)
 Board characteristics
◦ Percentage of independent directors
◦ Presence of audit committee
◦ CEO duality
 Audit quality
iii. 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. 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. 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. III. Limitations of using ratios
a. Accounting policies & methods

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 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.

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. 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. d. Creative accounting (cont’)
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

18. d. Creative accounting (cont’)
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

19. d. Creative accounting (cont’)
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 100 150
100 150
Debt 20 70
Equity 80 80
100 150
D/E 20/80= 25% 70/80= 87.5%

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
numbers
However, benchmarking has its problems…….

21. IV. Ratio Analysis Benchmarking
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

22. Problems in Cross-sectional Analysis (cont’)
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

23. Problems in Cross-sectional Analysis (cont’)
3. Activity of firms- look at segmental report
a) 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

24. Problems in Cross-sectional Analysis (cont’)
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

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. Problems in Time Series Analysis
1. Structural Issues
2. Accounting method changes &
classification

27. 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 company
1. 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

28. 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

29. Problems in time series – Change in
accounting methods & classification
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