Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Comparison of Financial Data:

Comparison 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 firm values its inventories by LIFO method and another firm by the average cost method, then direct comparison of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading. Sometimes enough data are presented in foot notes 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 conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry average 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 judgment about the future. Nothing could be further from the truth. Conclusions based on ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as starting point, as indicators of what to pursue in greater depth. they raise many questions, but they rarely answer any question by themselves.

In addition to ratios, other sources of data should be analyzed in order to make judgment 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 firm itself. A recent change in a key management position, for example, might provide a basis for optimization about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.

You may also be interested in other articles from “financial statement analysis” chapter:

1. Horizontal and Vertical Analysis
2. Ratios Analysis
3. Horizontal Analysis or Trend Analysis
4. Trend Percentage
5. Vertical Analysis
6. Accounting Ratios Definition, Advantages, Classification and Limitations:
7. Gross profit ratio
8. Net profit ratio
9. Operating ratio
10. Expense ratio
11. Return on shareholders investment or net worth
12. Return on equity capital
13. Return on capital employed (ROCE) Ratio
14. Dividend yield ratio
15. Dividend payout ratio
16. Earnings Per Share (EPS) Ratio
17. Price earning ratio
18. Current ratio
19. Liquid/Acid test/Quick ratio
20. Inventory/Stock turnover ratio
21. Debtors/Receivables turnover ratio
22. Average collection period
23. Creditors/Payable turnover ratio
24. Working capital turnover ratio
25. Fixed assets turnover ratio
26. Over and under trading
27. Debt-to-equity ratio
28. Proprietary or Equity ratio
29. Ratio of fixed assets to shareholders funds
30. Ratio of current assets to shareholders funds
31. Interest coverage ratio
32. Capital gearing ratio
33. Over and under capitalization
34. Financial-Accounting- Ratios Formulas
35. Limitations of Financial Statement Analysis

Other Related Accounting Articles:

• Fixed Assets Turnover Ratio
• Current Assets to Proprietor’s Fund Ratio
• Return on Shareholders Investment or Net Worth Ratio
• Over trading and Under Trading
• Creditors / Accounts Payable Turnover Ratio
• Return on Equity Capital (ROEC) Ratio
• Fixed Assets to Proprietor’s Fund Ratio
• Expense Ratio
• Dividend Yield Ratio
• Dividend Payout Ratio