Sunday, July 12, 2009

limitations of financial statement analysis

Although financial statement analysis is highly useful tool, it has two limitations that we must mention before proceeding any further. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.
Comparison of financial data
Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies' financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of financial data such as inventory valuations and cost of goods sold between the two companies may be misleading. Sometimes enough data is presented in footnotes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusions. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
The need to look beyond ratios
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any questions by themselves.
In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself. A recent change in a key management position for example, might provide a basis for optimism about the future, even though the past performance of the company (as shown by its ratios) may have been mediocre.

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