Question

Discuss the general limitations of financial statement analysis.

Answer 1

Financial Statements show the financial status of an enterprise for a given period. Statements are prepared for a given time frame. It is based on historic financial data only. There are other factors which such statements ignore. Following are the general limitation of financial statement analysis.

1. Historic Data: The first point of limitation is that financial statements are based on historic data. This data is for previous year. Analyzing the historic data would not really help in analyzing and making future plans. Plans are drafted for future only.
2. Does not provide accurate data: Financial Statements never give accurate data as they ignore many factors. For example, Brand valuation models, Goodwill valuation models have their own limitations which are used in making statements. Also, there are transactions happening without the notice of large enterprise. Such transactions may or may not include cash. Valuation of assets, receivables, securities are not accurate. Thus, overall statement has a problem of not giving accurate results.
3. Only Financial Data is used: Financial statements use only financial data. There are more significant things in the enterprise which must be considered while analyzing it. For instance, Human Resource, Competition, Business Environment etc. are ignored by financial statements. Thus, the analysis of only financial statements will not give accurate results.
4. Comparability issues: Comparing only financial data with other organization will not give perfect results. As every business has its own problems, it is difficult to assess the efficiency. Volume of transactions are also different in different organizations or volume of transactions are different in different periods of same organizations.
5. Issue of Reliability: Window dressing is almost enabled at all organizations at least at lower level.
6. Methods Conflict: Different methods are utilized at different levels. Valuation of Shares and Debentures, Depreciation calculation methods, inventory valuation methods, Cost price/ market price etc. are some of the examples.
7. Change of Accounting Policies: Accounting Policies must be uniform throughout the years. This enables comparability and analysis. If accounting policies are changing, analysis becomes difficult.
8. Changes in Business Environment: Business environment is usually ignored while analyzing financial statements. Economic, Political, Legal, Socio-cultural and Technological environments are the ones that affect the businesses directly or indirectly which is not appeared on statements.
9. Changes in Value of Money: Value of money is not constant. It changes period to period. Considering this is very important while analyzing financial statements.
10. Business Status: Status of business is also an important factor. If the business is newly formed or an old business, small scale or large scale business, FMCG or Durable goods, service sector etc. are the examples where comparison is not possible.
11. Analyzing Tools: There are tools to analyze financial statements. Which tool is used to analyze what information in the statement is important. Comparative, Commonsize analysis, Ratio Analysis are the examples of tools.

Conclusion: Analysis of financial statement is very essential for any managerial or directorial decision. But such analysis have its own limitations as mentioned above. Therefore, considering above factors are also important in addition to analysis of statements. Hence, above points become limitations of the analysis of financial statements.

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