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
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.