Financial Statement Analysis Limitations

Many things can impact the calculation of ratios and make comparisons difficult. The limitations include:


The use of estimates in allocating costs to each period.


The cost principle is used to prepare financial statements. Financial data is not adjusted for price changes or inflation/deflation.


Companies have a choice of accounting methods (for example, inventory LIFO vs FIFO and depreciation methods). These differences impact ratios and make it difficult to compare companies using different methods.


Companies may have different fiscal year ends making comparison difficult if the industry is cyclical.


Diversified companies are difficult to classify for comparison purposes.


Financial statement analysis does not provide answers to all the users' questions. In fact, it usually generates more questions!

Limitations of Financial Statement Analysis:

Although financial statement analysis has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Comparison of Financial Data:

Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies' financial data. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry average often suggest avenues for further  investigation.

The Need to Look Beyond Ratios:

An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment about the future.  Ratios should not be viewed as an end, but rather they should be viewed as starting point.

In addition to ratios, other sources of data should be analyzed in order to make judgment about the future of an organization. 

The analyst should look, for example, 

at industry trends, 

technological changes, 

changes in consumer tastes, 

changes in broad economic factors, and 

changes within the firm itself. 

A recent change in a key management position, for example, might provide a basis for optimization about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.

Cons

• While the apparent disadvantages of a financial statement analysis are few, there are disadvantages of performing ONLY a financial statement analysis. 

  
  

  If a company is operating in an ever- changing or highly competitive environment, its past results, as reflected in historical financial statements, may not be an indicator of future results. 

  Analysis of historical financial statements will not identify operational issues or inefficiencies or any favorable or unfavorable changes in the environment. 

  There are other non-GAAP measures (such as EBITDA -- earnings before interest, taxes, depreciation and amortization), which are excluded from audited financial statements but may provide valuable insights into the financial results of a business.

Summary

• Financial statement analysis is only one tool in evaluating a business. Supplementing the financial statement review with other analytical tools can overcome the limitations of only using one method of analysis. The review and analysis of financial projections, of the competitive or regulatory environment and of the market factors in which the company operates are additional tools for evaluating a business. These analyses, when combined with the historical financial statement analysis, will provide a more holistic approach as to where the company has been and to where it is headed.

  
  

  
  

  Advantages & Disadvantages of Financial Statement Analysis in Decision Making

  
  

  
  

  Market Patterns

  One disadvantage of using financial statements for decision making is that the data and figures are based on the market at that given time. Depending on the market, it may change quickly, so executives should not assume that the numbers from a previous financial statement will remain the same or increase. 
  
  
  Just because a company has sold 5 million copies of a product during one year does not guarantee it will sell the same amount or more. It may sell much less if a competitor releases a similar product.

  Sales Pattern

  Financial statements reveal how much a company earns per year in sales. The sales may fluctuate, but financial planners should be able to identify a pattern over years of sales figures. For example, the company may have a pattern of increased sales when a new product is released. The sales may drop after a year or so of being on the market. This is beneficial, as it shows potential and sales patterns so executives know to expect a drop in sales.

  At-One-Time vs. Continuous Analysis

  Another disadvantage is that a single financial statement only shows how a company is doing at one single time. The financial statement does not show whether the company is doing better or worse than the year before, for example. If executives decide to use financial statements for making decisions about the future, they should use several financial statements from previous months and years to ensure they get an overall picture of how much the company is doing. The financial statement becomes a continuous analysis, which is more useful than using a single statement.

  Budget Outline

  Another advantage of using financial statements for future planning and decision making is that they show the company’s budgets. The budgets reveal how much wiggle room the company has to spend on launching products, developing marketing campaigns or expanding the current office size. Knowing how much money is available for planning and decision making ensures that the company does not spend more than expected.
  
  
  
  

  Understanding the Limitations of Financial Statements

  
  

  Financial Statements ignore the qualitative aspects of running a company

  
  

  inancial Statements don't directly show you changes in the structure of the company

  
  

  For instance, a company could have added a new plant, launched a new product, be preparing for an acquisition etc.

  
  

  "Management's Discussion and Analysis