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Chapter One | Overview of Financial Statement Analysis 35

Consider interpreting the ratio of gasoline consumption to miles driven, referred to as miles per gal- ILLUSTRATION 1.4
lon (mpg). On the basis of the ratio of gas consumption to miles driven, person X claims to have the
superior performer, that is, 28 mpg compared to person Y’s 20 mpg. Is person X’s vehicle superior
in minimizing gas consumption? To answer that question there are several factors affecting gas con-
sumption that require analysis before we can properly interpret these results and identify the supe-
rior performer. These factors include: (1) weight load, (2) type of terrain, (3) city or highway driving,
(4) grade of fuel, and (5) travel speed. Numerous as the factors influencing gas consumption are, eval-
uating a gas consumption ratio is a simpler analysis than evaluating financial statement ratios. This
is because of the interrelations in business variables and the complexity of factors affecting them.

We must remember that ratios are tools to provide us with insights into underlying
conditions. They are one of the starting points of analysis, not an end point. Ratios,
properly interpreted, identify areas requiring further investigation. Analysis of a ratio
can reveal important relations and bases of comparison in uncovering conditions and
trends difficult to detect by inspecting the individual components that make up the
ratio. Still, like other analysis tools, ratios often are most useful when they are future ori-
ented. This means we often adjust the factors affecting a ratio for their probable future
trend and magnitude. We also must assess factors potentially influencing future ratios.
Therefore, the usefulness of ratios depends on our skillful application and interpretation
of them, and these are the most challenging aspects of ratio analysis.
Factors Affecting Ratios. Beyond the internal operating activities that affect a com-
pany’s ratios, we must be aware of the effects of economic events, industry factors, man-
agement policies, and accounting methods. Our discussion of accounting analysis later
in the book highlights the influence of these factors on the measurements underlying
ratios. Any limitations in accounting measurements impact the effectiveness of ratios.
Prior to computing ratios, or similar measures like trend indices or percent relations,
we use accounting analysis to make sure the numbers underlying ratio computations SEC CHARGES
are appropriate. For example, when inventories are valued using LIFO (see Chapter 4) The SEC has charged
and prices are increasing, the current ratio is understated because LIFO inventories (the numerous individuals
numerator) are understated. Similarly, certain lease liabilities are often unrecorded and and companies with
fraud and/or abuses
disclosed in notes only (see Chapter 3). We usually want to recognize lease liabilities
of financial reporting.
when computing ratios like debt to equity. We also need to remember that the useful- The SEC chairman said,
ness of ratios depends on the reliability of the numbers. When a company’s internal ac- “Our enforcement team
counting controls or other governance and monitoring mechanisms are less reliable in will continue to root out
generating credible figures, the resulting ratios are equally less reliable. and aggressively act on
abuses of the financial
Ratio Interpretation. Ratios must be interpreted with care because factors affecting reporting process.”
the numerator can correlate with those affecting the denominator. For instance, com-
panies can improve the ratio of operating expenses to sales by reducing costs that stim-
ulate sales (such as advertising). However, reducing these types of costs is likely to yield
long-term declines in sales or market share. Thus, a seemingly short-term improvement
in profitability can damage a company’s future prospects. We must interpret such
changes appropriately. Many ratios have important variables in common with other
ratios. Accordingly, it is not necessary to compute all possible ratios to analyze a situa-
tion. Ratios, like most techniques in financial analysis, are not relevant in isolation.
Instead, they are usefully interpreted in comparison with (1) prior ratios, (2) predeter-
mined standards, and (3) ratios of competitors. Finally, the variability of a ratio across
time is often as important as its trend.