Lois Kent has owned and managed the operations of a small chain of sporting goods stores for the past two years. She has asked her administrative assistant to provide her with some annual reports of other companies that sell sporting goods as well as

Question

some published reports showing norms for the sporting goods industry so that Lois can compare the financial ratios of her company with those of other companies that sell sporting goods. Discuss the limitations of using comparisons with other companies and industry norms, which Lois needs to remember.

Answer 1

Lois can learn some important things about her company by comparing her ratios to those of other companies, but she needs to remember the following limitations on such comparisons:

1. Some companies considered to be in her industry and included in the published norms may do more than just sell sporting goods. For example, some companies in the sporting goods industry may have development of new products or sales to professional teams as their mainstay of operations as opposed to sales through retail outlets. Thus, the financial ratios of these companies should not be used for comparison purposes.

2. Some companies that sell a large amount of sporting goods also sell other items. Wal-Mart and K-Mart would be examples of such companies that have a foothold in several industries. The ratios of companies like these would not be comparable to those of Lois's stores.

3. Companies in the same industry that differ significantly in size from that of Lois's company would have financial ratios that most likely should not be used for comparison purposes. Large companies have more liquid assets and greater buying power than a smaller company like Lois's.

4. Companies in the same industry may use different accounting methods than Lois does. The use of different methods for inventory costing and depreciation of assets, for example, would affect income statement and balance sheet amounts. Companies could appear to be different when perhaps they are very comparable. Lois could compare her ratios with these companies after recalculating their ratios using the same accounting methods that her company uses.