Financial Management & Cost Accounting

Module 4. Financial statement analysis

Lesson 23
IMPORTANCE AND LIMITATIONS OF FINANCIAL RATIOS

23.1 Usefulness of Financial Statements

Although financial statements provide information useful to decision-makers, there is much relevant information that they omit. Factors of market demand, technological developments, union activity, price of raw materials, human capital, tariffs, government regulation, subsidies, competitor actions, wars, acts of nature, etc. can have a dramatic effect on a company's prospects.

Although financial statement analysis is a 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 one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometime make it difficult to compare the companies' financial data. For example if one company values its inventories by the LIFO method and another firm by average cost method, then direct comparisons of financial data such as inventory valuation are 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 averages often suggest avenues for further investigation.

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 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 may questions, but they rarely answer any question by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. They 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 optimism about the future, even though the past performance of the firm may have been mediocre.

23.2 Limitations of Financial Statement Analysis

Many things can impact the calculation of ratios and make comparisons difficult. The limitations include

a) The use of estimates in allocating costs to each period. The ratios will be as accurate as the estimates.

b) The cost principle is used to prepare financial statements. Financial data is not adjusted for price changes or inflation/deflation.

c) Companies have a choice of accounting methods (for example, inventory LIFO vs FIFO and depreciation methods). These differences impact ratios and make it difficult to compare companies using different methods.

d) Companies may have different fiscal year ends making comparison difficult if the industry is cyclical.

e) Diversified companies are difficult to classify for comparison purposes.

f) Financial statement analysis does not provide answers to all the users' questions. In fact, it usually generates more questions.