Limitations / Weaknesses of Financial Statement Analysis
For accurate and precise analysis an analyst should be aware of the limitations to be faced. Financial
statement analysis has some inherent limitations / weaknesses.
Limitations of Financial Statements
For a sound decision the quality of information does matter. Since financial analysis is primarily based on information provided in financial statements produced & published by the company, the limitations of information presented in such statements becomes primary concern for the analyst. Enlisted below are some but not limited to these are inherent limitations of Financial Statements.
Financial statements are presented on cost convection basis which means figures do not include the effects of inflation or current market value. Financial analyst has to be careful while making the decisions particularly “predictive nature decisions” based on this information.
Representative of Past Events
Financial statements are, in fact, the record of past events of the company. These have little bearings on future events of the company e.g. technological obsolescence, management future decisions, changing trends in markets etc. Again careful consideration should therefore be taken by the analyst while making decisions, especially predictive nature decisions (investor decisions).
Quality vs. Quantity
Financial statements provide more quantitative information (numbers) as compared to qualitative information (little of such information is provided in Notes to the Financial Statements). For the purpose of financial analysis, both quantitative techniques and explanatory information are essential (as already discussed in financial statements analysis techniques). Therefore financial statements have limitations regarding qualitative information; for which we have to use other sources.
Results obtained by applying financial analysis techniques have manifold meaning when compared with the results of other companies operating in the same industry. However the issue arises when different accounting practices are used by different companies since it limits the comparability. For example one company uses FIFO method for valuing its inventory stock, the comparison of Quick Ratio (where closing inventory is subtracted from current assets) of such company might not be appropriate with the company which values its closing inventory on Weighted Average Method.
(Insight: FIFO and Weighted Average gives different values for the same amount of stock therefore are not comparable).
Limitations of Financial Analysis Techniques
Common size statements (Horizontal and Vertical analysis) and Ratio Analysis are mathematical formulae used to obtain specific information about the company. However as all other techniques some limitations are associated with these as well. For example:
Lack of Standardization
Formulae used in financial analysis techniques are not standards. In other words formulae used by me might not be same as used by you e.g. I might be using closing value of stock for calculation of my ratios while you might be using average value of stock (opening + closing)/2 in your ratio calculation.
Besides Earnings per Share ratio, for which IASB (International Accounting Standard Board) has issued an International Accounting Standard IAS -33, no ratio has any absolute formula to be used. For another example consider the Current Ratio, some people calculate current ratio by dividing all current assets with current liabilities, other with the opinion that some current assets are not representative of liquidity (e.g. prepayments) exclude these assets while calculating the ratio.
Art of Judgment than Science
As we have already discussed, Financial Analysis is more art of judgment than a science. There are no strict standards of what to do for extracting certain information. Suppose I am interested in short term liquidity of the company. I have options
- Only calculate the Current Ratio;
- Only calculate the Quick Ratio;
- Calculate both Current and Quick Ratios or
- Along with Current & Quick Ration, calculate some other ratios e.g. Cash Ratio
There is on standard rule to consider what will be the best for calculating short term liquidity. Thus techniques to be used are primarily based on judgment of the analyst. More experienced analyst will obviously make better decision.
Limitations of Explanatory Information
Explanatory (qualitative) information is essential for reaching at a precise and correct decision by financial analysis (as discussed earlier). As this information is obtained from various sources all the risks and limitations associated with secondary sources should be taken into consideration including but not limited to the following:
Availability of Information
The particular information required is not always easily available due to several reasons including non disclosure of information by the company as a competitive strategy. Therefore one has to be really vigilant for acquiring such information.
Reliability of Information
Information obtained from secondary sources i.e. sources other than the company e.g. magazines, newspapers should be verified for authenticity and correctness which is obviously time consuming and expensive. Thus this limits the extent to which information could be obtained (One has to consider the time & budget up to which he is willing to pay for the information).
There could be several other limitations depending and varying from case to case. I have highlighted some major limitations and tried to give you a concept of limitations associated with the financial analysis so that you can apply this to your individual cases.
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