Page 700 - Accounting Principles (A Business Perspective)

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Analysts must be sure that their comparisons are valid—especially when the comparisons are of items for
different periods or different companies. They must follow consistent accounting practices if valid interperiod
comparisons are to be made. Comparable intercompany comparisons are more difficult to secure. Accountants

cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for
inventory and cost of goods sold computations. Such a disclosure alerts analysts that intercompany comparisons of
inventory turnover ratios, for example, may not be comparable.
Also, when comparing a company's ratios to industry averages provided by an external source such as Dun &
Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting service. Thus, if
Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the
analyst. Net sales is sometimes preferable because all companies do not compute and report cost of goods sold

amounts in the same manner.
Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single
important event may have been largely responsible for a given relationship. For example, competitors may put a
new product on the market, making it necessary for the company under study to reduce the selling price of a
product suddenly rendered obsolete. Such an event would severely affect the percentage of gross margin to net
sales. Yet there may be little chance that such an event will happen again.
Analysts must consider general business conditions within the industry of the company under study. A
corporation's downward trend in earnings, for example, is less alarming if the industry trend or the general
economic trend is also downward.

Investors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the
seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much
lower than if the balance sheet date is in a season of low activity.
Potential investors should consider the market risk associated with the prospective investment. They can
determine market risk by comparing the changes in the price of a stock in relation to the changes in the average
price of all stocks.
Potential investors should realize that acquiring the ability to make informed judgments is a long process and

does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to
incorrect conclusions.
Relationships between financial statement items also become more meaningful when standards are available for
comparison. Comparisons with standards provide a starting point for the analyst's thinking and lead to further
investigation and, ultimately, to conclusions and business decisions. Such standards consist of (1) those in the
analyst's own mind as a result of experience and observations, (2) those provided by the records of past
performance and financial position of the business under study, and (3) those provided about other enterprises.
Examples of the third standard are data available through trade associations, universities, research organizations
(such as Dun & Bradstreet and Robert Morris Associates), and governmental units (such as the Federal Trade

Commission).
In financial statement analysis, remember that standards for comparison vary by industry, and financial
analysis must be carried out with knowledge of specific industry characteristics. For example, a wholesale grocery
company would have large inventories available to be shipped to retailers and a relatively small investment in

Accounting Principles: A Business Perspective 701 A Global Text