financial ratios 101, understanding financial ratio analysis basics, and best practices

financial ratio analysis first there's a
four-step process it starts with return on equity and the DuPont framework with
the DuPont framework we look at that return on equity and decompose it into
the profitability efficiency and the leverage dimensions because we know that
all three of those affect a company's return on equity to then find out a
little bit more detail about profitability efficiency and leverage we
can use the common size financial statements the common size financial
statements are the single most efficient tool at getting insights into a business
look at that common size balance sheet the common size income statement from
there we've identified efficiency or leverage or profitability problems we
need to drill down with some specific ratios with profitability ratios
efficiency ratios leverage ratios and finally all of this is to prepare us for
step four we need to talk with some people those are the four steps in the
financial ratio analysis process now remember that the raw material here the
material the data on which all this is based are the financial statements the
balance sheet a listing of a company's resources and obligations assets equal
liabilities plus equity if you've got assets you had to get the money to buy
them from somewhere that's the balance sheet the income statement revenues
minus expenses equal net income revenues of the amount of assets generated
through doing business expenses the amount of assets consumed in doing
business in a good business it's generating more assets than its
consuming meaning it has positive net income and finally the statement of cash
flows operating activities the things that a business does every day investing
activities investing in the productive capacity of the business by buying
machines and equipment and buildings and finally financing activities getting the
money to buy the assets borrowing money getting money from shareholders the
financial statements are the raw material for a financial ratio analysis
why do we do financial ratio analysis first if you're in a company if you're
running a company you do financial ratio analysis so that you can fix problems do
we have a profitability problem do we have an efficiency problem do we have a
leverage problem you can't fix problems until you have identified them and
financial ratio analysis allows you to use financial ratios use
common size financial statements use the DuPont framework to identify where your
problems are once you've identified where they are now you can start to fix
them if you're outside a company you do financial ratio analysis to make
decisions like should I make a loan to a company should I invest in a company as
an owner why is this company's profitability different than the
industry benchmark lots of why questions and really that's a key insight with
financial ratio analysis the numbers lead you to ask more questions about why
so please realize that yes it's true that you cannot pick stocks using
financial ratio analysis but you can identify good companies bad companies
healthy companies companies with problems using financial ratio analysis
it's those private companies those small and mid-sized companies the companies
that you might be asked to work for to invest in to loan money to to manage the
whole point of financial ratio analysis is to show you where the issues are the
numbers put you right here the numbers put you in the right room with the right
people asking the right questions you are an informed person as you go into
that room because you've done your financial analysis in the end of course
you're going to need to use your business judgment to make the decision
but you've got the big picture with your financial ratio analysis you're right
there with the people at the decision table armed with your financial ratio
analysis you're ready step1 in a financial analysis is
computing return on equity and then the DuPont framework analysis to look at the
profitability efficiency and leverage components we're now going to hone in on
the leverage component of return on equity with some specific ratios first
we'll look at current ratio which is one of the top five ratios of all time
then the debt ratio debt to equity ratio and then the times interest earned ratio
let's start with current ratio current ratio is a measure of liquidity
liquidity reflects the ability of a company to pay its obligations in the
short term short term we typically define as less than one year current
ratio is computed as current assets divided by current liabilities and let
me remind you what a current asset is and what a current liability is a
current asset is an asset expected to be used or turned into cash within one year
so for example accounts receivable that's a current asset because we expect
those accounts to be collected in cash within one year inventory is a current
asset because we expect that image going to be sold and then the cash collected
all within one year land is not a current asset typically because if we
come back a year from now we expect that land to still be their current asset a
cash is also a great current asset because already is cash so our current
assets are the liquid assets the ones that we expect to become cash soon in
less than one year similarly current liabilities are the liabilities that we
expect to have to pay within one year accounts payable is a good example of a
current liability we're going to pay our suppliers what we owe them within one
year so the current ratio reflects the balance between the assets that we have
that are going to become cash within one year and the liabilities that we have
that we're going to have to pay within one year and we like to see a bit of a
cushion there so the current ratio for nordstrom is 2.1 in 2013 for Dillard's
is also over 2 the general rule of thumb for current
ratios is that they're typically greater than two banks like to see current
ratios typically greater than two in fact it's very common
in bank loan contracts that a bank will say to a borrower your current ratio has
to stay above a certain level above 1.5 or above 2 and if you fall below 2 we
start to get nervous maybe you're not going to be able to pay us when you are
supposed to pay us and so your loan is in default so the rule of thumb is
current ratios should be greater than 2 but that's an old rule of thumb in the
new world that we have now the technology world companies are able to
manage their current assets much more efficiently companies don't need as much
inventory as they used to need because their information systems can track
their inventory very carefully and so companies don't need to have as much
extra inventory lying around cash can be managed more tightly accounts receivable
can be tracked more precisely so in recent years current ratios have slipped
below 2 in fact you see a list of very safe financially safe companies here all
with current ratios less than 2 that's normal these days so the old rule of
thumb the rule that your mom and dad learned when they went to school was
current ratio should be about 2 all current ratios are often less than 2 now
but in general remember that the current ratio reflects liquidity the ability of
a company to pay its debts in the short term and we like to see that steady if
that starts to slip in any given company we get nervous about that company's
ability to pay its debts in the short term and the DuPont framework we're looking
at the three components of return on equity profitability efficiency and
leverage let's look at leverage investors putting their investment in
the company but if that investment is not enough to buy all the assets they
need to fulfill their business objectives they need to borrow money
they need to leverage their investment that makes the business larger with the
same initial shareholder investment that's reflecting the assets to equity
ratio a measure of leverage why does a business want more assets
because more assets generate more sales that's reflected in the efficiency
measure why does a business want more sales more sales means more net income
that's reflected in profitability with more leverage a company's return on
equity can be higher even with the same amount of shareholder investment so
let's look at some specific measures of leverage measures that are commonly used
debt ratio very simple measure total liabilities divided by total assets the
rule of thumb is that for large companies a debt ratio is usually
between 50 and 60 percent so when I see that 50 percent debt ratio for Dillard's
I think fine they're normal they've leveraged they've borrowed about the
same amount as most companies borrow when I see that debt ratio of Nordstrom
on the other hand of 75 percent I now have some questions I'd like this chief
financial officer the CFO for Nordstrom to come here and tell me what was the
business decision that you made so that you have so much leverage why do you
have 75 percent leverage when most of your competitors have substantially
lower leverage what's the decision there that's debt ratio total liabilities
divided by total assets the fraction of financing that was obtained through
borrowing another measure of leverage is called the debt to equity ratio total
liabilities divided by total shareholder investment we've got a simple company
investors invest $1 they then go out and borrow $1 and with those $2 can now buy
2 dollars of assets 2 dollars of assets coming from $1 of borrowing liability
and $1 of owner investment let's now compute three different measures of
using the same common set of data the debt ratio $1 of liabilities divided by
two dollars of assets 50% half of the financing has come through borrowing the
debt to equity ratio total liabilities divided by total equity is one it's one
to one we have exactly as much borrowing as we do shareholder investment the
assets to equity ratio is two total assets is two shareholder investment is
one we have twice as many assets as we could buy with our own invested money
that means we had to leverage our investment you see that there are three
different measures of the same underlying leverage why do we have three
well it's just a matter of taste people use different ratios they all reflect
the same thing so how do we know which one to use well the way you know is ask
the person on the other side of the table which leverage ratio are you using
for example somebody tells you that the temperature is 22 degrees so hot or cold
it depends on what measure you're using are you using the Fahrenheit scale then
22 degrees means it's cold below freezing you better have a code on are
you using the Celsius scale 22 degrees it's comfortable room temperature are
you using the Kelvin scale well then it's almost as cold in fact a little
colder than it is on Pluto the same number 22 means a different thing
depending on what scale you're using same thing with these leverage ratios
let's say that somebody tells you to the leverage ratio is 0.5 what does that
mean well are they talking about the debt ratio they're talking about the
debt ratio a debt ratio of 0.5 means that half of the total financing has
been borrowed 50 percent of total financing is borrowed total liabilities
divided by total assets or are they referring to the debt to equity ratio
that's 0.5 well then that means that the borrowing is half as much as the
shareholder investment that works out to be this one-third of the financing has
come from borrowing and two thirds twice as much has come from shareholder
investment what does it mean if the assets to equity ratio is 0.5
it means shareholders have invested money the managers of the company have
ruined half of those assets and now the assets are only half
as much as what the shareholders originally put in so you can see that a
leverage ratio of 0.5 what does that mean it depends on the scale so when
you're talking with somebody and they say the leverage ratio is 0.5 you need
to stop them right there and say wait are you talking about debt ratio debt to
equity ratio or assets to equity ratio are you talking about Fahrenheit Celsius
or Kelvin you cannot interpret the number until you know what ratio is
being used now one common feature of all these measures of leverage is that they
all come from balance sheet numbers assets liabilities owner investment
there's also a very important income statement focused measure of leverage
and this is called times interest earned these numbers come from the income
statement its operating income divided by the amount of interest expense that's
the benefit of leverage there are also risks associated with leverage once you
borrow money you now have the relentless fixed cost of that interest and whether
things are going well or going poorly you still have to pay that interest what
that means is if your business experiences a short-term downturn you
may not live through that short-term downturn because you have to pay your
interest you could go into bankruptcy because you can no longer pay your
interest and are those borrowed resources being used efficiently to
generate enough profit to be able to pay the interest on the borrowed money if
not so you're digging yourself deeper and deeper into a financial hole there
are benefits to leverage there are risks to leverage prudent leverage in a
business can increase the return on equity but leverage has to be used
prudently you since we're gonna be using the financial
statements to do our analysis let's review the primary financial statements
there are three the balance sheet the income statement and the statement of
cash flows let's briefly review what is contained in each one of these three
primary financial statements and we'll start with a mother of all financial
statements the balance sheet the balance sheet is a listing of a company's assets
its resources its valuable things its cash its land its inventory the things
that it holds to sell those are its assets and the other part of the balance
sheet is a listing of where the company got the money to buy those assets the
liabilities and the equities the balance sheet embodies the accounting equation
one of the greatest inventions of the human mind invented in Italy over 500
years ago a listing of the assets which is easy anybody can list assets but the
insight is to then also list where do we get the money to buy those assets the
liabilities and the equities that's the balance sheet now assets they're
valuable resources cash for example accounts receivable money that is owed
by other people to a company that's an asset land buildings equipment all of
these are resources that a company uses in accomplishing its objectives those
are the assets we're gonna use a hypothetical example to do some
financial ratio analysis so let's make up this example now it's we'll call the
company very cleverly uncertain company we're not sure how sure how uncertain
company is doing so here are the assets for this hypothetical uncertain company
cash 700 accounts receivable money owed by other people to this company on
certain company of 4,000 inventory the things that uncertain company holds to
sell to other people and finally property plant and equipment land
machines buildings of 8,000 total assets 14,500 and let me see if you remember
what I just said about the accounting equation if a company has assets of
14,500 then that same company also has to have sources of financing to buy
those assets what are those sources well possible sources are liabilities
liabilities are obligations to repay money or to provide a service in the
future so Walmart for example where does Walmart gets most of its inventory the
things that Walmart on its shelves to sell to you and me
suppliers finance it suppliers saying you can pay us later we call those
accounts payable other liabilities Disney has borrowed money on a long-term
basis United Airlines has a very interesting
liability when you and I fly on United Airlines we pay first and fly later in
the interim United Airlines owes us a ride on an airplane that's an obligation
that's a liability that's listed on United Airlines balance sheet the
liabilities for our hypothetical uncertain company are to accounts
payable two thousand five hundred and long-term debt four thousand five
hundred total liabilities seven thousand meaning of those fourteen thousand five
hundred dollars in assets that uncertain company has seven thousand of those
dollars came from borrowing in these two different forms the second source of
financing to buy assets is owner's equity money provided to the company by
the owners and owners can do this in two general ways one is that the owners can
take money out of their personal savings and put it in the company they were
working for years saving a thousand dollars here $1,000 there now they put
it in the company we call that paid in capital that's one way that owners
invest in their company a second way that owners invest in a company is by
keeping profits of the company in the business we call this retained earnings
the profits of a business belong to the owners the owners can take those profits
out and use them to buy groceries or to buy a boat or whatever else they want to
do or the owners can say let's put those profits back in the business we call
that retained earnings paid in capital and retained earnings are the amount of
money that are provided to the company by the owners to then buy assets the
equity of uncertain company is paid in capital of 1500 and retained earnings of
6,000 so let's see if this adds up the assets of uncertain company 14,500
where'd an uncertain company get the money to buy those assets $7,000 was
borrowed and 7,500 was invested either directly or indirectly by the owners
it's perfect the accounting equation always works assets equals liabilities
plus equity if you've got assets you had to get the money somewhere to buy those
assets and that's true for Citibank for Walmart for Apple or for that corner
drugstore you've got assets you gotta get the money to buy
those assets from somewhere and those relationships which assets in what mix
and where did we get the money to buy those assets those tell very important
things about a business its strengths its weaknesses and its risks we're going
to use the balance sheet in financial ratio analysis the balance sheet the
mother of all financial statements you the second primary financial statement
is the income statement revenues minus expenses equals net income we use the
terms revenues and expenses all the time so let's make sure we know what these
words mean in an accounting context revenue means the amount of assets
generated in doing business and different companies generate assets in
different ways Walmart for example generates assets by putting things on
shelves that you and I buy Walmart's inventory we pay Walmart for those
things that's how Walmart creates assets Microsoft creates assets by creating
software and hardware that you and I then buy and we pay Microsoft for those
things Disney has consumer products they have cruises they have theme parks we
pay to use those things or to buy those products and that's how Disney generates
assets revenue is the amount of assets generated in doing business hopefully
the assets generated are less than the assets consumed expenses are the amount
of assets consumed in doing business for example Microsoft consumes assets by
paying programmers by paying for equipment Walmart consumes assets by
buying the inventory that sells to you and me and paying rent by seeing its
buildings to depreciate by paying its employees McDonald's consumes resources
by buying food buying paper by renting facilities in each case the revenues
hopefully are more than the expenses that are consumed in generating business
all of this is put together in the income statement net income revenues
minus expenses equal net income net income is a very sophisticated economic
measure it's the net amount of assets generated by a business through its
business operations this is the income statement to do our ratio analysis let's
use the income statement for a hypothetical company uncertain company
sales that's their revenues minus their expenses cost of goods sold wage expense
research and development expense and advertising expense leaving net income
of $700 we're going to use this income statement for uncertain company to
understand is this company earning lots of money or a little money and if it's
not very much why not which expenses are causing problems the
income statement the second of the primary financial statements
you you third primary financial statement is the
statement of cash flows conceptually a statement cash flows is quite simple
cash in cash out the inside of accountants is to separate those cash
flows into three categories operating activities investing activities and
financing activities those three categories of cash flows are what are
reported in the statement of cash flows operating activities are what companies
do every single day collect cash from customers pay cash to buy inventory pay
cash to employees pay cash for rent for advertising for research and development
all those things are operating activities think of operating activities
as the things that a business does every single day and hopefully a company would
generate cash from its operating activities you would hope that a
business would be collecting more cash than its spending on a daily basis
the second category in the statement of cash flows is investing activities this
investing means investing in the productive capacity of the business
buying machines buying land buying buildings those are investing activities
in contrast to operating activities which happen every single day investing
activities happen occasionally you don't buy land and buildings every
single day you do that on occasion operating activities things that our
business does every day investing activities investing in the productive
capacity of business happens occasionally the third category in the
statement of cash flows is financing activities and this is exactly what it
sounds like it's financing borrowing money repaying those loans getting cash
from investors paying dividends to investors getting the capital or
financing to buy the assets that a business needs a way to think of the
statement of cash flows as financing activities I'm getting the financing in
the capital to buy the assets the investing activities to then conduct the
operations the operating activities these are the things that a business
does the statement of cash flows is built around operating investing and
financing activities now I have some bad news about the statement of cash flows
you're going to have to say goodbye to the statement of cash flows at this
point because most financial ratio analysis is done without cash flow
ratios the reason for this is that the cash flow statement is so new it's
less than 30 years old in contrast the balance sheet and income statement are
over 500 years old so the standard financial statement and
ratio analysis formulas don't really include financial ratios related to cash
flow the balance sheet the income statement the statement of cash flows
those are the three primary financial statements in our ratio analysis we'll
focus on the first two the balance sheet and the income statement now let's look at some specific
profitability ratios and we'll start right at the top of the income statement
with gross profit percentage gross profit is sales minus cost of goods sold
if Nordstrom's sells you something for $100 and they pay $65 to buy that thing
from their supplier then Nordstrom's gross profit is $35 and their gross
profit percentage is 35% the fraction of the selling price that Nordstrom gets to
keep right off the top and in a retail organization or in a manufacturing
organization or an organization that sells a service you would hope that this
gross profit percentage stays stable now the gross profit percentage is very
important because if you start to have problems they're the only way to make up
for that further down in the income statement is by belt-tightening
pay our employees less pay less for electricity pay less for rent it's tough
if the gross profit percentage starts to suffer it's hard to maintain profits by
tightening up on your overhead expenses let's go down the income statement one
more step and look at operating profit percentage operating profit is the
profit made by a company by doing what it normally does from its operations
it's gross profit minus those overhead expenses the selling general and
administrative expenses and in a business we want to see operating profit
percentage be stable now there's a ratio that is related to operating profit and
it's called EBIT da so let's go step by step here we'll start with the little
brother of eBay da EBIT EBIT the acronym stands for earnings before interest and
taxes it's a synonym for operating income but even sounds much more
sophisticated EBIT DA the DA part stands for depreciation and amortization these
are legitimate business expenses the wearing out of our machines and our
buildings and other assets but they don't involve cash this year so EBIT da
can be viewed as an approximation of our operating cash flow and is a very common
measure EBIT da if you're hanging around business people and you say 'hey but
you'll feel immediately like one of the club so a very important ratio is e but
none of by sales and again we see that here for
Nordstrom's and remember what this reflects is an approximation of
operating profitability from a cash standpoint and we would expect our
operating profitability always to remain stable now Amit does a very well-known
number and I'll just give you when appraisers are appraising small
businesses a simple rule of thumb is this a small business is worth that
businesses EBIT da x 5 now I'm not giving you appraisal advice here but
EBIT dies such a commonly used number that it's used in appraisals and other
things so make sure you remember eBay da earnings before interest taxes
depreciation and amortization let's talk about another class of
financial ratios ratios that involve comparing a financial statement number
with a market value number and the primary ratio in this category is the
p/e ratio the price to earnings ratio this is one of the most famous ratios of
all time it's a connection between the amount of net income that a company is
generating this year its earnings and the price or the market value that
people are willing to pay for that company and as you would think if a
company has higher growth prospects in the future the price earnings ratio is
going to be higher because of this reason when you buy a company are you
buying its past or you buying its future you're buying the future and if the
future looks very large compared to the earnings right now you're going to have
to pay a premium to buy that company so higher price earnings ratio reflects
market expectations that earnings or net income in the future will be much higher
than they are now most PE ratios are between 10 and 30 almost all companies
have p/e ratios between 10 and 30 which means this if the company has income of
this year of $1 and the p/e ratio is 10 to buy that company I have to pay 10
dollars now sometimes PE ratios can get crazy
back around the year 2000 that p/e ratio sometimes were in excess of 2000 meaning
if you had earnings of $1.00 people would pay $2,000 to buy that company it
was crazy but what it reflected was people's expectations that earnings at
that time were small compared to what earnings were going to be in the future
large expected future growth so the p/e ratio reflects how fast market investors
think that a company's earnings will grow in the future
profitability ratios in general are our way to drill down and figure out why
companies having profitability problems or profitability successes there are
specific profitability ratios that we can look at the gross profit percentage
what profit are we making right off the top as we sell our products the
operating profit percentage what's the profit from the things that we do on a
daily basis EBIT da divided by sales reflects a cash
offering performance measure return on sales that's everything put together and
we want to look at the different components using the common size income
statement and finally the price earnings ratio shows that connection between
market values of companies and their current net income or earnings remember
profitability is just one dimension of the DuPont framework profitability
efficiency and leverage it's the dimension on which we usually
focus most of our attention and it's a very important dimension but remember
that it's only one okay we just finished looking at the
profitability ratios now let's look at the efficiency ratios we have three
specific efficiency ratios we're going to drill down on first one is number of
days sales in inventory the second is average collection period and the third
is the fixed asset turnover what are those well the number of days sales and
inventory tells me how long on average does my inventory stay with me until
it's sold the average collection period tells me on average how long from when I
sell something on credit till I collect the cash those two together stays sales
in inventory and average collection period indicate what we call the
company's operating cycle then the third efficiency ratio we're going to look at
is our fixed asset turnover that is how many dollars worth of sales do our fixed
assets generate so let's look first at the inventory turnover we buy inventory
and the question is how long until we sell that inventory can we calculate on
average how long our inventory sits in our store for example well we have a
measure for that it's called days sales in inventory and the first step in
calculating day sales and inventory is we take a measure called our inventory
turnover that is how often do we turn our inventory over every year think of
it this way I have inventory how long until I sell it all buy more sell it all
buy more sell it all how many times do I do that in a year there's an easy way to
calculate that and that is to take our cost of goods sold and divide that by
our average inventory for the year now why use average inventory for the year
well cost of goods sold occurs throughout the year and our inventory
comes and goes throughout the year as well so tamasha cost of goods sold
throughout the year measure we approximate how much inventory do we
have on average throughout the year we'll take our beginning inventory
balance at our ending inventory balance divided by two to get an approximation
of how much inventory did we have on average throughout the year
so to calculate inventory turnover cost of goods sold divided by average
inventory you oK we've calculated how long our
inventory is with us by calculating days sales in inventory we can do the same
thing with receivables if we sell that inventory on credit how long until we
can expect to get the cash we may have terms of net 30 but we can
calculate how close to that net 30 for example we are getting by calculating an
hour average collection period there are two steps in calculating average
collection period just like with inventory the first thing we do is
calculate our accounts receivable turnover we take our sales revenue this
time remember with the inventory we took cost of goods sold with accounts
receivable we're going to take our sales number and we're going to divide that by
average account receivable and to review why do we do average account receivable
remember sales occur throughout the year we don't want to compare sales
throughout the year with account receivable at the end or accounts evil
at the beginning it would be nice if we had an average account receivable
balance as well and we calculate that by just taking beginning balance plus our
ending balance dividing by two and then dividing that into our sales revenue
what do we do with these numbers well as we did with inventory we'll simply
divide them into 365 two to have a day's measure that we can compute our average
collection period it turns out if money is tied up in receivables that
constrains what you can do as a business just as when money is tied up in
inventory it constrains what you can do as a business we need to keep an eye on
how efficiently we are managing our inventory how efficiently armet we are
managing our receivables as well you there are potential pitfalls associated
with financial ratio analysis and we've got to be aware of those pitfalls so
that we can carefully do our analysis and carefully apply our results first is
financial information is not all the value relevant information that's
available about a firm secondly financial statements from different
companies are sometimes not comparable third common mistake is we always seem
to be searching for one problem when it could be that there's a multitude of
reasons the company's doing very well or doing very poorly and then the fourth
common mistake with financial ratio analysis is we weight information
differently we either look at history too much the distant past too much are
we entering the recent past we've got to be careful when we're using information
to apply it appropriately let's take a look at the first one financial
statements don't contain all value relevant information it turns out
financial statements are only one part of the information spectrum there's lots
of information available about a company out there and while financial
information is relevant and reliable it's not everything and the danger is
the precision of the financial statement numbers can be very misleading we may
think it's more important than it is because there are numbers attached to it
so we got to be very careful when using financial information to not overweight
it in terms of it's important for example for publicly traded companies in
the United States company stock prices fluctuate every day in response to all
sorts of news economy-wide news industry news company specific news every day and
yet financial statements come out once every three months for for publicly
traded companies we've got to make sure that we incorporate all information and
not overweight the financial information we've got to be very careful sometimes
financial information with its precision can lead us to assume that it's more
important than it is financial statements the second one financial
statements from different companies are sometimes not comparable they may
classify items differently they may use different accounting methods or
assumptions or we may have a conglomeration we may have a business
that's a conglomeration of a variety of business segments so before we do
comparisons of two financial statements to companies we've got to make sure that
it's apples and apples we've got to be very careful so we've got to be careful
when we're comparing one company with another that not only are they in the
same line of business but they use the same accounting methods and they
classify items on their financial statements the same we've just got to be
careful when doing comparisons third potential pitfall is our tendency to
search for a single smoking gun one reason that a company is doing well or
one reason that a company is doing poorly we have this human tendency to
want to solve a mystery by being able to point to one thing turns out in a
business context usually there's not one single reason for poor or great
performance often it's a series of small issues that lead to a very big issue
when it comes to business it's often a collection of events that determines
whether a company does well or a company does poorly a fourth pitfall when we
anchor on information that may not be as relevant financial ratio analysis uses
the past to help us forecast the future recent past is much more relevant than
the distant past so we've identified four potential pitfalls when it comes to
using financial ratio analysis first we've got to remember the financial
statements don't contain all the value relevant information when it comes to a
firm there's information about the economy about the industry about the
firm specific information the financial statements while important aren't
everything we need to be careful that we don't assume that the precision of the
numbers means they're more on that information is more important often it
is not the second we've got to be careful when we use financial statements
and we're comparing companies to make sure they're comparable companies may be
in different industries we've got to be careful it could be that they use
different accounting methods we need to make sure that the methods underlying
the numbers are consistent so that when we compare we can reach a reasonable
conclusion the third our tendency to search for a smoking gun there's got to
be one reason this firm is doing well or one reason this firm is doing poorly
often will find there are multiple reasons all the little things that that
add up to a big thing it's seldom one big thing and then the fourth potential
pitfall we've got to be careful when using the past to predict the future
turns out the more relevant information is the recent past we don't want to go
too far back in predicting the future because that information may or may not
be as relevant as just the last couple of years be careful when doing financial
ratio analysis it's very powerful when used appropriately you

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