Financial Statement Analysis | Purpose & Limitations

Financial statement analysisWhat is the purpose of financial statement analysis?

The Financial Statement Analysis and interpretation are basic to the decision-making process for creditors, stockholders, managers, and other groups. The external analyst, such as a bank credit officer, must answer questions related to a company’s earnings capacity, ability to meet interest and principal obligations, ability to pay dividends, and general financial strengths and weaknesses based on the financial statement analysis.

Many limitations are inherent in financial statement analysis, partly because the statements themselves have the following limitations.

Limitations of financial Statements

1. Financial statement analyzed in aggregate form: Many financial statements are prepared only in aggregate form, without a breakdown by such important factors as product line, geographical area, fixed costs, variable costs, and responsibility centers.

2. Financial statement is analyzed based on estimates: One of the limitation in the analysis of financial statement is that, many dollar items included in the statements are estimates. Such items include valuing inventory (and thus cost of sales), computing the annual expense for depreciation, determining doubtful accounts (bad debts), and deciding whether to write off goodwill or carry it on the balance sheet as an intangible asset. Thus, financial statements are not exact, although they often give an impression of preciseness by being shown “to the last penny.”

Note: The tax law may specify the period over which an asset must be depreciated for tax purposes, but good financial accounting practice may require a different period. Tax rules are not a foundation for sound financial reporting and analysis.

3. Different accounting methods and techniques in financial statement analysis: Different companies, even in the same industry, may use different accounting methods and techniques in the financial statement analysis process, which is another major limitation. Among the more common alternatives are the last-in – first-out (LIFO) versus first-in – first-out (FIFO) inventory methods and accelerated depreciation versus straight-line depreciation. These limitations can materially affect the comparability of statements among companies.

Most companies in the steel industry adopted LIFO accounting in the 1950s, as soon as it was allowed. Consequently, a considerable portion of their inventory is still carried at 1950s’ prices. This makes their inventory-to-sales relationship look like a food retailer, which turns its inventory eight or more times a year.

4. Financial statement analysis does not project the actual problems of a company: Financial statements do not show many factors that affect the financial condition and potential profitability of a company. Such factors as order backlog, proposed capital expenditures, and the importance of intangible assets (such as patents and intellectual property) and key personnel are often not revealed.

5. Variable environmental conditions in financial statement analysis: Environmental conditions are constantly changing. Thus, the economic and operational environment is usually different for the same company from one period or year to the next. Also, the environment may be different for companies of the same relative size operating in the same general industry depending on such factors as geographic location and product niches. A chain of nursing homes operating in the Midwest may have significantly different financial characteristics from a similar-sized one operating in the Southeast. The characteristics also will differ depending on whether the chain serves the private-pay or Medicaid market.

6. Financial statement analysis relies on historical accounting data: Another major limitation of Financial statement analysis is that it is based on historical accounting data; analysis of these statements depicts past relationships. The analyst and the business owner are more interested in what is going on now and what is probable for the future. Although a business’s characteristics seldom change rapidly and analysis relies heavily on past data in predicting the future, the analyst must be aware the future may be different.