Limitations of Financial Statement Analysis

The Limitations of Financial Statement Analysis refer to the restrictions associated with generating analysis reports after going through the financial statements of a company. These financial statements provide the necessary information which the users, who are the internal or external stakeholders of organization, for making more informed and wiser decisions.

Though these reports are of great use to companies and their stakeholders, their limitations must be known to understand the extent to which one should rely on such reports. Some limitations include non-comparability of the financial statement across different companies due to adopting different accounting policies and procedures, non-adjustment of the inflationary effects, dependency on the historical data, etc.

Limitations of financial statement analysis include all challenges and risks involved in following the conclusions derived from the analysis of financial statements of organizations. Normally, the financial statement analysis reports are prepared after going through different financial statements that a company prepares. Hence, the uses andlimitations of financial statement analysis become necessary to explore.

Being a consolidated report based on what all other statements have to convey, these are highly trusted. And this is where the limitations come into the scene. Before one trust these report completely, it is important for them to be aware of the restrictions and risks associated with this financial statement analysis conducted by experts.

Investors and the management browse through these financial statement analysis reports to check the potential and growth prospects of the company and major issues in the organization, respectively. Based on the growth prospects, the investors decide whether to invest or not in a business. On the contrary, the management uses the financial statements to check the progress of the company and also detect the major issues to take relevant actions to improve. Understanding these limitations would let the stakeholders and other users of the reports to determine their extent to which they must depend on the conclusions derived.

While there are times when investors believe in the progress and success of the companies completely based ion these conclusions, a few instances lead to an opposite scenario. Such negative results might include reduction in investments fund in a business, actions taken by managements to detect and work on the loopholes.

The limitations of financial statement analysis are many, including both the minor and major ones. Listed below are five limitations, which affect a business as well as the decision-making of users the most. Let us discuss the limitations of financial statement analysis:

#1 - Quality of Underlying Data

Financial Statement analysis, as the name suggests, depends heavily on the data provided by the company in its financial statements. Hence, the accuracy of the analysis depends on the accuracy and genuineness of the financial statements.

Although financial statements are audited, they are not always foolproof. Sometimes, they don’t present the real picture of the company’s financial standing. It can happen for a few reasons – to maintain a particular position/image in the market, to impress bankers/prospective investors. When this is the case, no matter how good the methods and ratios applied are, it will not be an accurate analysis.

One of the biggest accounting frauds that grabbed eyeballs worldwide was the Enron scandal, which came to light in October 2001. CEO Jeffrey Skilling had manipulated the financials to hide vast amounts of debt piled up due to unsuccessful deals and projects. This company's share price was at a high of USD 90.75 in mid-2000, which fell to less than USD 1 after the news of the fraud broke out. Such is the impact of misrepresentations in financial statements.

Such frauds continue to come to light despite the authorities worldwide taking several steps to counter them. It proves to be a significant hindrance to relying on financial statement analysis for investment decisions.

#2 - Standalone Analysis

The results of a company viewed individually don't provide the reader with a holistic picture of the company's position in the market – in comparison with their competitors and the market averages.

At the outset, it might seem like the company is on a downward slope. Picture this – A company that operates in the "X" sector shows a growth of 5% as against the previous year when it had an increase of, say, 6%. However, if the growth of the "X'' sector was lower than 5%, it shows that the Company has surpassed the industry average. Despite the low industry average, the Company has overcome some of the industry's hindrances during the period to emerge on the "right" side of the average. Hence, it would not be wise to write off the Company going by its standalone results.

It is also essential to consider other factors, such as changes in government policies that might affect the industry – whether positively or adversely, the socio-political situation in the regions where the Company has substantial operations. These are not factored in financial statement analysis, but they have real financial consequences on companies.

#3 - Historical Figures + Assumptions = Projections

Financial statements are the documentation of a company's past performance (Profit and Loss statement) and the amounts at which its assets and liabilities stand on the date of its preparation (Balance Sheet). Following are some of the steps that financial analysts take to arrive at the results of financial statement analysis –

• Extract data from financial statements
• Study relevant market data
• Extrapolate the two
• Identify patterns, if any
• Form certain assumptions based on these patterns and past data
• Arrive at projections

From the above, it is clear that the financial statement analysis results also depend on the assumptions made. Assumptions are personal and depend on the person making them, and hence they might differ from person to person. And this renders the financial statement analysis vulnerable to incorrect or unreasonable results.

#4 - Timeliness/Relevance

Like every data, report, or analysis, a financial statement analysis has a limited shelf life. And for an analysis to be effective, it also has to be made and consumed on time, after which it loses its worth. Since we live in a dynamic world, coupled with the wonders of the internet, things change so fast today.

Analyses are made based on particular situations that exist when making the analysis. And if those situations change, the analysis will have less or no relevance. If a reader/prospective investor gets hold of analysis at such a time, s/he might make the wrong decision.

#5 - Qualitative Factors

Reiterating the point at which we started this topic, several factors contribute to the success or lack thereof of any company which is not captured in the financial statements. These are the qualitative factors that you cannot put a number on. For example –

• The expertise of management in the industry,
• the ethical standards of the management as well as employees,
• quality of training given to employees to ensure that they are up to date with changing times,
• vendor and customer relationship management,
• employee morale, in other words, how connected the employees feel with the mission and vision of the Company – and what efforts the management is putting in to boost the employee morale

These non-financial aspects and many more can affect a Company’s future as much as the financial factors and hence must not be ignored. However, in typical financial statement analysis, the methods used (like ratio analysis, horizontal analysis, vertical analysis, etc.) are generally based on numbers, and these qualitative factors are not considered.

This has been a guide to what are Limitations of Financial Statement Analysis. We explain top 5 limitations for users to decide how much to depend on them. You can learn more about financing from the following articles –

• Types of Financial Analysis
• Top 15 Financials Analysis Techniques
• Annual Financial Statements
• Financial Analysis Examples