In order to make rational business decisions, Financial Statement Analysis (FSA) is the diagnostic and investigative analysis of Financial Statements keeping aside the disadvantages of financial statement analysis performed by a financial analyst. Accounting for Financial Statement Analysis is the process of converting the raw financial data included in the financial statements into usable information that can be utilized to make choices. But there are few important limitations of financial statement analysis which we will understanding it in this article.
Financial statements are comprised of the Statement of financial reports, financial position and other financial statements that are to be framed in accordance with the applicable financial reporting framework. Auditors and various other analysts analyses the financial statements and provide their report on the same; however, there are limitations of financial statement analysis due to the volatile nature of the industry, business conditions, and other factors that affect the financial statements.
Limitations of Financial Statement Analysis
Despite the fact that financial statements have several advantages, there are some limitations of financial management and some limitations of financial statement analysis. Because the analysis is carried out on the basis of information included in the financial statements, it is possible that the data is inaccurate. Let us overview on it.
Not a Substitute for the Application of Judgement
It is not possible to substitute competent judgement for a study of financial statements. It’s simply a means to an end, not an end in itself. Final judgments are made by an interested person or analyst based on his/her intellect and competence in making the decision.
Standalone Analyses
When the results of a business are evaluated individually, the reader does not receive a comprehensive picture of the company’s position in the market and unable to understand the objectives of financial planning in business – in contrast to their competitors and the market averages.
Disadvantages of financial statement analysis example: Companies in the manufacturing sector have experienced growth of 5 percent in recent years, as opposed to the prior year, when they saw a rise of, say, 6 percent. On the surface, it appears as though the firm is on a declining trajectory. If, on the other hand, the manufacturing sector’s growth rate is less than 5 percent, it indicates that the Company has outperformed the industry average. In spite of the low industry average, the Company has managed to overcome some of the difficulties that the industry was experiencing at the time. Therefore, based on the Company’s standalone performance, it would not be prudent to write down the company.
Apart from this, it is also necessary to take into account other aspects such as changes in government policies that may have an impact on the sector – either favorably or negatively – as well as the socio-political environment in the regions where the Company has significant operational presence. These are not taken into consideration while analyzing financial statements, yet they have actual financial repercussions for businesses.
Analysis Comes from the Past and the Present Data
The major limitations of financial statement analysis is that the financial expert and auditor analysts base their conclusions on historical data, as well as current situations and outcomes, among other things. If there has been an improvement, they will issue positive reports; otherwise, they will issue qualified reports.
However, they do not take into consideration the future plans of the enterprise as well as future economic and market conditions because these conditions can change at any point in time due to the unpredictable nature of the world. It is not necessary that a report showing positive points in the future will always show favorable points since the conditions under which the report was created are subject to change.
There is a Problem with Comparability
The size of a company concern varies in accordance with the amount of transactions it does each day. As a result, the data from various financial accounts lose their capacity to be compared. This is the primary disadvantages of financial statement analysis in business and for an organization and should prepare a goals of financial management before moving to next level in business.
Ignores the Qualitative and Non-Financial Aspects of the Situation
The financial analysis simply shows the monetary elements of the situation. For lack of a better expression, these assessments solely take into account information that can be represented only in monetary terms. There is a lack of information in these evaluations about a company’s managerial effectiveness, growth possibilities, and other non-operational effectiveness.
Figures from the Past Plus Assumptions Equals Projections
When a company’s previous performance (profit and loss statement) is documented, financial statements are the documentation of the levels at which its assets and liabilities exist as of the date of their production (assets and liabilities statement) (Balance Sheet). Listed below are some of the processes that financial analysts follow in order to arrive at the conclusions of financial statement analysis:
- Identify trends, if any, in financial statements and previous data to arrive at strategic financial planning projections.
- Extrapolate important market data from financial statements to get at predictions.
- It is evident from the foregoing that the outcomes of financial statement analysis are also dependent on the assumptions that are made.
Assumptions are subjective and dependent on the individual who is making them, and as a result, they may differ from one person to the next. Furthermore, as a result, the limitations of financial statement analysis is susceptible to producing inaccurate or unjustified outcomes.
The Dependability of the Information that has Been Provided
However, in today’s world of competition, everyone wants to attract investors, and one way to do so is by window dressing the accounts and presenting the company in a more favorable light. Auditor and various analysts establish the reliability of the financial statements and reports presented by the management of the enterprise, but they only verify figures on test check basis.
As a result, the credibility and transparency of reports produced by independent third parties are subject to the limitations imposed by management on their dependability and openness.
The Interim and Final Picture
Due to the fact that just the interim report is included in the financial analysis, the information provided is insufficient. They fall short of providing a complete and comprehensive picture. Every businessmen should be aware of benefits of financial planning in business and understand that this main concern about financial accounting and plan to overcome these disadvantages of financial statement analysis as quick as possible.
Regarding Relevance and Timeliness
A financial statement analysis, like any other data, report, or analysis, has a shelf life that must be respected. Because we live in a dynamic environment, aided by the miracles of the internet, things change at an alarmingly rapid pace these days. Aside from being effective, an analysis must also be produced and consumed within a reasonable time frame, failing which it becomes worthless.
Analyses are carried out in response to specific conditions that exist at the time of the analysis’s completion. And if those circumstances alter, the analysis will become less or perhaps completely irrelevant. Consequently, a reader or prospective investor who comes across analysis at this point may find himself or herself in a position of making the erroneous judgement. Such limitations of financial statement analysis for an organization create a huge impact on readers and investors.
Misleading Information
The financial analysis is unable to identify any significant changes in accounting methods and practices, as a result. As a result, they may give incorrect or misleading information.
Limitations of financial statement analysis example: The Enron affair, which first came to light in October 2001, was one of the largest accounting frauds in history, drawing attention from all around the world. CEO Jeffrey Skilling had falsified the company’s financial statements in order to conceal massive sums of debt that had accumulated as a result of failed transactions and initiatives. The share price of this company reached a peak of USD 90.75 in mid-2000 before plummeting to less than USD 1 upon the discovery of the fraud. Misrepresentations in financial statements have these kind of ramifications.
Different Methods of Accounting Estimates and Policies
The valuations produced by management, such as the value of inventories, the valuation of fixed assets, the valuation of investments, and so on, are based on a variety of techniques and accounting principles, as well as estimations made by management.
Furthermore, unless the technique or policy implemented is not allowed under the law, the auditor or financial analyst cannot raise any concerns about it. As a result, the various approaches and estimations provide a variety of findings and, consequently, a variety of financial circumstances.
Window Dressing
The word “window dressing” refers to the manipulation of finances in order to conceal important facts and the presentation of financial statements in order to portray a position that is better than it actually is. As a result of this limitations of financial statement analysis, it cannot be used to determine whether or not a company is under excellent management.
Changes in the Price Level Does Not Take into Account
The financial analysis fails to account for the change in the level of the price. Rather than in actual terms, the statistics for different years are calculated using nominal values. This is again an important disadvantages of financial statement analysis in business and for a company which owners should be aware of it.
Changes in Accounting Methods are Mandated by Legislation
There are circumstances in which a business has been using a certain accounting technique for years and then the legislation changes and the enterprise is forced to modify its accounting policies or procedures in order to comply with the new law.
As a result, due to the fact that accounting standards have changed from previous periods, it is not justified to compare the statement with previous data. While conducting their analyses, analysts and auditors should bear this restriction in mind.
Restrictions on the Use of the Tools for Analysis Application
When doing an analysis, an analyst will use a variety of different tools. Despite the fact that the implementation of a specific tool or approach is dependent on the analyst’s ability and experience, there are certain general guidelines to follow. It is unavoidable that the findings will be deceptive if an inappropriate instrument or approach is used.
Not Free of Prejudice
The accountant’s and management’s own judgement and discretion play an essential part in setting the figures for many items on the Financial statements like balance sheet and income statement. In the case of depreciation, provision for doubtful debts, stock value, and other similar items, personal judgement is required.
As a limitations of financial statement analysis, financial statements are not completely free of errors. A similar argument may be made about the lack of objectivity in the Analysis of Financial Statements (AFS).
There was No Evaluation of Managerial Ability
The conclusions drawn from the examination of financial accounts should not be interpreted as an indicator of either excellent or bad management. As a result, management competence cannot be determined by financial analysis.
Changes in the Business Environment
It is very unpredictable in the markets; market situations and conditions can shift at any point in time, sometimes resulting in a recession and other times resulting in favorable market conditions. Since one’s reports are dependent on the present situations, which may or may not be the same all of the time and might change in the future. One should be conscious about the disadvantages of financial statement analysis that unfavourable conditions can transform into favorable ones and vice versa when writing them.
Conclusion
Due to the volatile nature of the financial markets, the reliability of financial statements is determined by the analysis and audit report issued by various market experts and auditors. However, the report issued by them is subject to a number of limitations of financial statement analysis, such as the fact that it is based on current and past conditions.
Because every business employs a unique set of accounting principles and techniques, there is a disadvantages of financial statement analysis and it is not appropriate to compare the financial performance of two companies. Furthermore, because the report is based on the analyst’s expertise and judgement, the auditor’s assessment and the expert opinion may differ, with both being correct in their respective positions.