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Explain where ratio analysis falls short and how segment data can be used

CFA® Level I · Financial Statement Analysis · Financial Analysis Techniques · FSA.5.c

The idea

Ratios have no meaning in isolation: they require comparison with the company's own history, with peers or with an industry benchmark, and each comparison has difficulties. Accounting choices differ, which is why adjustment precedes comparison. Diversified companies have no clean peer group at the consolidated level, and a single set of consolidated ratios can average two businesses with opposite characteristics into a figure describing neither. Segment disclosures are the remedy, giving revenue, profit and assets by business line, though the segments are defined by management and can be redefined.

A practice question

From the question bank, with the reason each wrong option is wrong.

Why does a ratio require a benchmark to be meaningful?

  1. Because ratios are defined differently by different data providersWhy not: A real nuisance when using third-party data, and a reason to check definitions. It is not why a single figure conveys nothing on its own.
  2. Because a ratio only conveys information relative to history, peers or an industry norm — correct
  3. Because ratios cannot be computed without oneWhy not: They compute perfectly well from one company's statements. It is interpreting the result that needs something to compare against.

A current ratio of 1.4 is strong in one industry and weak in another. The figure alone carries no verdict.

A harder one

A conglomerate reports an operating margin of 11%. Why may that describe none of its businesses?

  1. Because margins are unaudited at the consolidated levelWhy not: The consolidated figures are the audited ones. The margin is arithmetic derived from them.
  2. Because consolidation excludes the smallest divisionWhy not: Consolidation includes every controlled entity. Nothing is left out for being small.
  3. Because it can be the average of a 25% software business and a 3% distribution business — correct

An average between two very different structures is a number no part of the company actually earns.

The hardest tier

A company restructures its reporting segments this year. What does that cost the analyst?

  1. Nothing, since the consolidated totals are unchangedWhy not: The totals are unchanged, which is exactly why the loss is easy to miss. What disappears is the ability to track the parts.
  2. The ability to compute consolidated ratiosWhy not: Those still compute from the primary statements, which segment definitions do not affect.
  3. The time series, because the new segments cannot be compared with the old ones — correct

The remedy for consolidation depends on a boundary the reporting company draws, so a redrawing can quietly end the comparison it was supporting.

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