Updated July 20, 2023
Introduction to Financial Statement Analysis
Financial Statement consists of Statement of Financial Position, Financial reports and other financial reports which are to be framed according to applicable financial reporting framework and auditor and various other analysts analyze the financial statements and give their report on the same but this analysis has certain limitations because of volatile industry, business conditions, and other factors.
Investors heavily rely on the reports issued by Auditors and various analyst and according to the report investors plan their investment. Auditor reports on the true and fair view of the financial statements. He verifies the financial statements by vouching and verification on test check basis and on the basis of his past experience and then issue the report stating whether the financial statements show the true and fair view or not. So, the report is one of the reliance point for investors and prospective investors.
Similarly, the other analyst of market analyze the financial statements and on the basis of their analysis, remarks in auditor’s report and financial result of the specific business enterprise, the analyst issue the report by stating that whether it is safe and good to invest funds in particular company and rate that company on the basis of industry performance. But the reports issued by the auditor and the analyst has certain limitations like judgements are based on past experience of experts and based on current market conditions which are subject to change due to its volatile nature etc.
Limitation of Financial Statement Analysis
Reports issued by various analyst and auditor are subject to limitations and every investor must aware of the limitations, some of the financial statement analysis are stated as under:
The Analysis Is Based on Past and Present Data and Conditions: The analysis of the auditor and various analysts are based on past data and present conditions and results. They compare the past data with the present position and if there is the improvement they will issue the positive reports and otherwise the qualified report, but they do not consider the future plans of the enterprise and future economic and market conditions as these conditions can change at any point of time due to unpredictable nature. The report which shows the favorable points is based on conditions which can be changed hence it is not necessary that report will always show the points in the future also.
Reliability of The Data Presented: Auditor and various analyst make reliability on the reports and financial statements presented by the management of the enterprise and they only verifies the figures on test check bases but in the world of competition everyone wants to attract the investors and hence one can do the same by window dressing of accounts and showing the better position of the company. Hence the reports issued by independent third parties are subject to the limitation of reliability and transparency by management.
Valuation by Different Methods of Accounting Policies and Estimates: The valuations made by management like valuation of inventory, valuation of Fixed assets, valuation of Investments, etc. are based on different methods and accounting policies and estimates by the management. And the auditor or financial analyst cannot question on the method or policy adopted unless being not acceptable by law. The different methods and estimates show different results and accordingly different financial positions.
Change in Accounting Methods Enforced by Law: There are situations when an enterprise is following one accounting method for years and suddenly the law changes and enterprise have to change the accounting policies or methods as required by law. Hence because of different accounting policies from past periods it is not justifiable to compare the statement with the past data. Analysts and auditor while analyzing should keep this limitation in mind.
Inflationary Effects Are Being Ignored: As inflation is increasing day by day and it affects every business organization which results into rise in expenses and probably a decrease in profits. With this, too every investor, analyst or auditor make the comparison of the current position with the past data but they should also keep that limitation in mind that the time value of money changes.
Limitations of Methods Application for Analysis: Every Analyst whether the auditor or the market analyst analyzes. and make reports based on the experience and skills of the analyst and we must take this fact in mind that the experience and skill of analysts is not the same in any manner. Hence the reports issued by them are subject to limitation as it is based on personal judgments of the analyst.
The Reports of The Analysis Should Not Create the Assessment of Managerial Ability: On the basis of the reports issued by an analyst, the people or some stock analyst question the management about their inability to bring the company at the industry standards and forget the truth that it is based on market conditions, situations, the response from buyers, the attitude of employees, credit worthiness etc. Hence one should keep the fact in mind that unfavorable result doesn’t mean the poor managerial or performance ability.
Change of Business Conditions: The market is highly unpredictable, the market situations and conditions can change at any point of time, sometimes results into recession sometimes favorable conditions. Hence being an analyst, one should make clear that the reports are subject to the current conditions and which may or may not be the same all the time and can change in the future, the unfavorable conditions can turn into favorable and vice versa.
The reliability of financial statement is based on the analysis and audit report issued by the various market experts and the auditor as the case may be but the report issued by them are subject to various limitations like the report is based on the present and past conditions which can change at any time due to its volatile nature. Every organization uses different accounting policies and methods hence it is not justified to compare the results of two organizations. Also, the report is based on the experience and judgment of the analyst hence auditor’s opinion and expert opinion can vary and both are right at their position.
This is a guide to Limitations of Financial Statement Analysis. Here we also discuss the introduction to Financial Statement Analysis along with explanation and respective limitations. You may also have a look at the following articles to learn more –