Enhanced understanding financial ratios results from using and interpreting the ratios, not from memorizing them. It cannot be emphasized enough as to how important the interpretation of financial statement ratios are. This is a necessarily qualitative and intellectual process, which requires the analyst to have understood the firm's specific strategy in the context of the industry and to be aware of any underlying accounting choices that affect the data used in the computation of the financial ratios being examined.

There are alternative methods for examining profitability. Simple approaches, such as earnings-per-share, common-size, and percentage change analysis, as well as subjective redefinition of profits. However, the how to interpret different levels of the key profitability proceeds through four levels of depth. Level 1 involves measures of profitability for a firm as a whole: the rate of ROA and the rate of ROCE. Level 2 disaggregates ROA and ROCE into important components. ROA disaggregates into profit margin for ROA and assets turnover. ROCE disaggregates into profit margin for ROCE, assets turnover, and capital structure leverage components. Level 3 disaggregates the profit margin into various expense-to-sales percentages and disaggregates assets turnover into individual asset turnovers. Level 4 uses product and geographic segment data to study ROA, profit margin, and assets turnover more fully.

Analyzing financial statement ratios is the forensic part of the process of investigating. In this step, the analyst must dig deep to understand why ratios are what they are. How do the ratios reflect the economics of the industry and the specific strategy of the firm? Do the ratios suggest that a firm is performing better or worse compared to its peers or is performing better or worse through time? Are there accounting choices that hinder the ability to productively use ratios to better understand the firm?

Required:

Discuss what questions and considerations should analysts raise when comparing financial ratios to:

Earlier Periods?

Other Firms?