How creative accounting affects ratio analysis

How creative accounting affects ratio analysis

Ratio analysis assumes that the numbers are fairly presented. If accounting has been “creatively” managed, then the ratios that depend on those numbers are also distorted.

Here’s how it can impact key categories of ratios:

(a) Profitability ratios

Examples: gross profit margin, net profit margin, ROA, ROE, EPS.

If revenue is accelerated or expenses are deferred:

• Profits are overstated → margins, ROA, ROE look stronger than they really are.

If provisions/depreciation are understated:

• Current profit is inflated, future periods may suffer (profit volatility).

Effect: Investors may believe the firm is performing well and growing, when it is actually just manipulating timing of income and expenses.

(b) Liquidity ratios

Examples: current ratio, quick ratio.

If the firm:

• Classifies short-term liabilities as long-term,
• Inflates current assets (e.g. overdue receivables not written down),

Then:

Current ratio and quick ratio can look healthy, even though the firm may struggle to pay its short-term debts.

Effect: Banks and creditors may underestimate short-term cash flow problems.

(c) Gearing / solvency ratios

Examples: debt–equity ratio, debt ratio, interest coverage.

Using off-balance sheet financing or misclassifying liabilities can:

• Understate total debt,
• Overstate equity (if assets are inflated and not impaired).

Interest coverage may look comfortable if profit is overstated.

Effect: Users may think the company has low risk and plenty of borrowing capacity, when in reality it is highly leveraged.

(d) Efficiency (activity) ratios

Examples: inventory turnover, receivables turnover, asset turnover.

If inventories or receivables are not properly written down:

• Inventory turnover may appear reasonable because obsolete stock is not recognised.
• Receivable turnover may look good while many debts are actually uncollectable.

Effect: Management may appear efficient while assets are not being used effectively.

(e) Trend and comparison analysis

Ratio analysis is often used to:

• Compare performance over time (trend analysis), and
• Compare with other firms (cross-sectional analysis).

Creative accounting breaks both:

Trend analysis

• If the company “manages” profit differently each year (e.g. big bath one year, then smooth profits), trends become meaningless.
• Growth in profit or improvement in ratios may reflect changes in accounting methods, not real improvement.

Cross-company comparison

• Different firms use different levels of aggressiveness in estimates and policies.
• A more conservative company may look weaker in ratios than an aggressive company, even though it is ctually healthier.
• This reduces comparability, which is one main objective of accounting standards.

Overall impact on users of ratio analysis

Because ratio analysis is only as good as the underlying data, creative accounting leads to:

• Misleading conclusions about profitability, risk, and performance.

Wrong decisions by:

• Investors (buying/selling shares based on inflated EPS, ROE).
• Lenders (granting loans based on manipulated gearing and liquidity ratios).
• Management (believing targets are met when performance is artificially boosted).

Loss of trust in financial reporting once manipulation is revealed.

So, when using ratio analysis, analysts should always remember:

Ratios are useful tools, but they are not foolproof. 

If accounting numbers are distorted by creative accounting, the ratios will also be distorted.

In short

“Therefore, the usefulness of ratio analysis depends heavily on the reliability and integrity of the underlying financial statements. Creative accounting reduces that reliability, making ratio analysis less accurate and potentially misleading.”