Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it 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:

Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies' financial data. For example if one firm values its inventories by LIFO method and another firm by the average cost method, then direct comparison of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading. Sometimes enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. 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. Nothing could be further from the truth. Conclusions based on ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as starting point, as indicators of what to pursue in greater depth. they raise many questions, but they rarely answer any question by themselves.

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.

 

You may also be interested in other relevant articles: Horizontal Analysis or Trend Analysis Trend Percentage Vertical Analysis Limitations of Financial Statement Analysis Accounting Ratios definition, advantages, classifications and limitations Financial Ratio Formulas Profitability ratios: Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) ratio Dividend yield ratio Dividend payout ratio Earnings Per Share Ratio Price earning ratio Liquidity ratios: Current ratio Liquid /Acid test / Quick ratio Activity ratios: Inventory/Stock turnover ratio Debtors/Receivables turnover ratio Average collection period Creditors/Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading Leverage ratios or long term solvency ratios: Debt equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage or debt service ratio Capital gearing ratio Over and under capitalization

 

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