Question

1. The balance sheet provides information concerning liquidity, financial flexibility, and information for calculating various financial ratios. The balance sheet serves as a major indicator of an enterprise's ability to survive. Nevertheless, the analysis of the balance sheet should be approached with a clear understanding of the limitations of the statement.

What are the major limitations of the balance sheet that should be recognized in analyzing the statement? Explain how these affect the analysis of the balance sheet.

Answer 1

Balance Sheet depicts the Assets and Liabilities/Equity as on a particular date. It is part of Financial Statements published by the firm

Major Limitations of Balance Sheet

1. It is based on historical cost. it does not reflect the current cost. For Example- Fixed Assets. The Current prices are reality and hence major differences between historical and current prices will make Balance Sheet redundant. Hence Ratio analysis is based on historical values and may not not prove much useful based on current trends in prices
2. Window Dressing. Since Balance Sheet indicates the position of business the values of assets and liabilities may be altered to show good position of the business. This may prove to be unethical and harmful to shareholders. Hence to show good ratios numbers may be built up. For example to show Current ratio of 2:1 Inventories may be increased which will adversely affect days on hand.
3. Different Methods of presentation adopted gives different results. For example Inventory can be valued based on FIFO method, LIFO method or Average cost method. Hence results across the firms may vary when the have different methods of inventory valuation.
4. Balance Sheets carry sometimes assets which arise out of accounting like Goodwill , Discount on issue on bonds, etc. The treatment of these in Ratio analysis varies the results.