Question

Identify potential issues in interpretation of financial information, providing examples to support your ideas.

Answer 1

Financial statement interpretation is a judgmental process which aims to estimate current and past financial positions and the results of the operation of an enterprise, with primary objective of determining the best possible estimates and predictions about the future conditions.

Financial statement analysis and interpretation can be a very useful tool for understanding a firm’s performance and conditions. However, there are certain problems and issues encountered in such analysis which call for care, circumspection, and Judgment.

Problems in Financial Statement Analysis and interpretation

Lack of an Underlying Theory: The basic problem in financial statement analysis is that there is no theory that tells us which numbers to look at and how to interpret them. In the absence of an underlying theory financial statement analysis appears to be ad hoc informal and subjective. From a negative viewpoint, the most striking aspect of ratio analysis is the absence of an explicit theoretical structure.

Conglomerate Firms: Many firms, particularly the large ones, have operations spanning a wide range of industries. Given the diversity of their product lines, it is difficult to find suitable benchmarks for evaluating their financial performance and condition. Hence, it appears that meaningful benchmarks may be available only for firms which have a well-defined industry classification.

Window Dressing: Firms may resort to window dressing to project a favorable financial picture. For example, a firm may prepare its balance sheet at a point when its inventory level is very low. As a result, it may appear that the firm has a very comfortable liquidity position and a high turnover of inventories. When window dressing of this kind is suspected, the financial analyst should look at the average level of inventory over a period of time and not the level of inventory at just one point of time.

Variations in Accounting Policies: Business firms have some latitude in the accounting treatment of items like depreciation, valuation of stocks, research and development expenses, foreign exchange transactions, installment sales, preliminary and pre-operative expenses, provision of reserves, and revaluation of assets. Due to diversity of accounting policies found in practice, comparative financial statement analysis may be vitiated. For example, while some use Straight line method for calculating depreciation others might use double declining method to do the same.

Another problem in interpretation arises when a firm has some favorable ratios and some unfavorable ratios and this is rather common. In such a situation, it may be somewhat difficult to form an overall judgment about its financial strength or weakness. Multiple discriminated analysis, a statistical tool, may be employed to sort out the net effect of several ratios pointing in different directions.