Question

What are the limits of financial statement analysis and how do managers manipulate ratios for their own personal gain.

Answer 1

Limits of Financial Statement Analysis:

1. The entire financial statements contains only financial information relevant to the prior periods. This past period information is analysed in order to make some future plans , budgets , estimates etc. This is always not correct as the presumption of the future predictions is based on the premise that the future will be like the past which may not be true at all .
2. This kind of financial statement analysis is only a tool that helps in the decision making and not a substitute for the judgement that is made by the analyst using his sound mind, diligence and the expertise that he has.
3. Many a time the financial statements of the organizations are window dressed in order to present a rosy picture of the financial health of the organization. In this case the analysis based on the financial statements that are window dressed are meaningless and do not serve the purpose for which that analysis was made.
4. When the accounting methods and accounting policies followed are not uniform over a number of years them the financial statement analysis is of no purpose and value as the data is not just different over the period but also not comparable.

   Managers manipulate ratios for their own personal gain in the following manner:

5. One of the ways is to exaggerate current period earnings which is declared on the income statement by artificially increasing revenue and gains, or by reducing current period expenses. This approach makes the financial condition of the company look better than what it is in actual reality in order to meet the pre defined expectations. When this is done , it leads to a manipulation in Net profit ratio, Interest coverage ratio etc
6. Another way that they would manipulate the ratios is that they will adopt a reverse technique i.e to show that the company is not doing well in order to ward of those people who are interested in acquiring the company.
7. Managers overvalue the inventory and thereby that leads to overvaluing the assets and thereby the current ratio and the quick ratio.