Tuesday, 11 April 2017

Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

  1. Am I comparing like with like?
  2. Is there an explanation?
  3. What am I comparing it with?
  4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:
  • Consider a company that writes off research and development costs as overheads as soon as they are incurred.
  • Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
  • A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:
  • Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
  • The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
  • The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
  • This does not mean that the position has deteriorated dreadfully and the company is in trouble
  • The change in the period of credit is an accepted feature of the trade and happens every year.
  • It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

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