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OTHER FINANCIAL RATIOS

Each of the financial ratios that we have described involves accounting data only. But managers also compare accounting numbers with the values that are established in the marketplace. For example, they may compare the total market value of the firm`s shares with the book value (the amount that the company has raised from shareholders or reinvested on their behalf). If managers have been successful in adding value for stockholders, the market-to-book ratio should be greater than 1.0.

You can probably think of a number of other ratios that could provide useful insights into a company`s health. For example, a retail chain might compare its sales per square foot with those of its competitors, a steel producer might look at the cost per ton of steel produced, and an airline might look at revenues per passenger mile flown. A little thought and common sense should suggest which measures are likely to provide insights into your company`s efficiency.

Using Financial Ratios

Many years ago a British bank chairman observed that not only did the bank`s accounts show its true position but the actual situation was a little better still.11 Since that time accounting standards have been much more carefully defined, but companies still have considerable discretion in calculating profits and deciding what to show in the balance sheet. Thus when you calculate financial ratios, you need to look below the surface and understand some of the pitfalls of accounting data. The nearby box discusses some ways in which companies can manipulate reported earnings.

For example, the assets shown in Pepsi`s 1998 balance sheet include a figure of $8,996 for ¬intangibles. ­ The major intangible consists of ¬goodwill, ­ which is the difference between the amount that Pepsi paid when it acquired several companies and the book value of their assets. Pepsi writes off a proportion of this goodwill from each year`s profits. We don`t want to debate whether goodwill is really an asset, but we should warn you about the dangers of comparing ratios of firms whose balance sheets include a substantial goodwill element with those that do not.

Another pitfall arises because many of the company`s liabilities are not shown in the balance sheet at all. For example, the liabilities include leases that meet certain tests for example, leases lasting more than 75 percent of the leased asset`s life. But a lease lasting only 74 percent of asset life escapes the net and is shown only in the footnotes to the financial statements. Read the footnotes carefully; if you take the balance sheet uncritically, you may miss important obligations of the company.