Financial ratios are easy-to-use tools that allow us to standardize financial in

Question

Financial ratios are easy-to-use tools that allow us to standardize financial information for comparison. As we learned in the chapter, we can utilize these measures to compare a company's performance to its past performance, but also to compare firms of different scales and sizes within the same industry. These measures can be compared to industry averages for easier interpretation, despite varying limitations.

Despite this standardization, is it expected that larger firms will always be better rated than smaller firms in these measure, due to their relative size and other outside factors that can skew these measures?

Does it follow that, even with ratios regulating similar company's financial statements, a larger company's days in inventory measure or operating profit margin would automatically be better than a smaller company's, within the same industry, due to advantages such as economies of scale and buying power?

Explanation / Answer

Albiet standardized ratios there is are significant differences between the financial characterstics between large and small firms:

>Liquidity ratios: The current assets of a small firm vary extreamely due to high activity whereas those of a large firm are more upto the industry standards. But we must also take into account the fact that smaller firms have lessor inventory contributing to a more liquid CA portfolio. On the other hand current liabilities increase with the size of the firm.

>Activity ratios: As the asset/ inventory size of small firms is small as compared to large firms, the Sales-to-Asset and Sales-to-Inventory ratios are generally higher for smaller firms as compared to large firms.

>Leverage ratios: Smaller firms have limited sources of long term debt as compared to larger firms, so they tend to carry out their business by taking higher short term debt. Hence, leverage ratio for smaller firms is larger as compared to large firms.

>Profitability ratio: Profitability ratios vary significantly from firm to firm. Generally smaller firms have better Return on Sales ratio but there is not a significant difference between large and small firms in terms of Return on Equity ratio.

There is no general theory to support the claim that large firms are better off in financial ratios as compared to small firms. 'Economies of scale' do exist but so do 'diseconomies of scale'. Although large firms are able to sell more but so do are their competetors, leading to reduced margins. In case of smaller firms, they have limited number of clients and lower sales volumes but they tend to charge higher margins.

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