Financial Statement Analysis Limitation
The analysis financial statement provides the necessary information which is required by the users of the financial statement, but it has some limitations which include non-comparability of the financial statement across different companies due to adoption of different accounting policies and procedures, non-adjustment of the inflationary effects, dependency on the historical data, etc.
Here we have listed out the top 5 limitations that reduce the dependability of results from financial statement analysis –
- Quality of Underlying Data (are not foolproof)
- Standalone Analysis (no complete picture)
- Historical Figures + Assumptions = Projections
- Timeliness/Relevance for Limited Period
- Doesn’t consider Qualitative Factors
Top 5 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 on which it is made.
Although financial statements used for analysis are usually audited, they do not always foolproof. Sometimes, they don’t present the true picture of the company’s financial standing. This can happen for a few reasons – to maintain a certain 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 effective analysis.
One of the biggest accounting frauds that grabbed eyeballs across the world was the Enron scandal which came to light in October 2001. Where the then CEO Jeffrey Skilling manipulated the financials to hide huge amounts of debt that had piled up due to unsuccessful deals and projects. The share price of this Company 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 across the world taking several steps to counter them. This proves to be a major hindrance to relying on financial statement analysis for investment decisions.
#2 – Standalone Analysis
Results of a company viewed individually doesn’t provide the reader with a holistic picture of the position of the company in the market – in comparison with their competitors and the market averages.
Picture this – A company that operates in the “X” sector shows a growth of 5% as against the previous year when it had a growth of, say 6%. On the outset, it might seem like the company is on a downward slope. However, if the growth of the “X’’ sector was lower than 5%, it shows that the Company has surpassed the industry average. It shows that, despite the low industry average, the Company has overcome some of the hindrances that the industry faced 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.
Apart from this, it also important 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 as 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 results of financial statement analysis also depend on the assumptions made. Assumptions are personal and depend on the person making it and hence it might differ from person to person. And this renders the financial statement analysis it vulnerable to incorrect or unreasonable results.
#4 – Timeliness/Relevance
As is with every data, report or analysis, a financial statement analysis as well as a limited shelf life. Since we live in a dynamic world, coupled with the wonders of the internet, things change so fast today. And in order for an analysis to be effective, it also has to be made and consumed in a timely manner, after which it loses it’s worth.
Analyses are made based on certain situations that exist at the time of 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 end up taking the wrong decision.
#5 – Qualitative Factors
Reiterating the point which we started this topic with, there are a number of factors that contribute to the success or lack thereof, of any company which are 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 to 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, and vertical analysis, etc.) are generally based on numbers and these qualitative factors are not considered.
Summary
With this write-up, are we trying to completely write off the advantages of financial statement analysis and its many methods? Definitely not! On the contrary, it is believed to be an effective tool that helps in investment related decisions.
However, when an investor/stakeholder refers to an analysis of financial statements of a company, s/he must be wary of these factor in the mentioned points and then make an informed decision. As Warren Buffet has said, “Risk comes from not knowing what you are doing”.
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