Limitation of financial statement analysis
Dependence on historical costs – At first, transaction recorded at their cost. When examination balance sheet, this is an issue, the value of profit report possibly changes over the time. Certain projects (e.g. marketable securities) will act according to the change of its market value to change, but other projects (e.g. fixed asset) will not change. Therefore, if presents a large part of amount bases on the historical costs, then the balance sheet will possibly have misleading.
Intangible assets not recorded – Many intangible assets are not recorded as assets. Instead, any expenditures made to create an intangible asset are immediately charged to expense. This Policy may be greatly underestimated the value of the business, particularly those who are spending a lot of money to build brand image. This kind of problem mainly happen on intellectual property rights of the venture companies, this is a particular problem because it generates minimal sales.
No predictive value – All the financial statement publish on the market was historical result and it do not brief the company financial position up to date. Obviously, this document only provide the position of the company for period before but do not contain any future prediction. For instance, an enterprise can do some legal “window dressing” with asking all the buyer to buy more stock before the annual report being publish, so the sales will increase dramatically. (Accounting Tools, 2018)
Based on specific time period – Users of financial statements can only get a wrong view of the financial results or cash flow of a business by viewing one reporting period. Any period may affect the normal business performance of the business, possibly due to a sudden surge in sales or seasonal effects. It is best to look at a large number of consecutive financial statements to gain a better understanding of the results in progress.
No discussion of non-financial issues – The financial statements merely a report to show the company whether profit from the pass but it do concern the non-financial issue which really affect the company performance, such as the company’s environmental focus, or it is the level of cooperation between local communities. A good statement may make company fall on non-financial issue because the awareness of social responsibility keep increasing.
Market Trends – Financial statement not enough info for analysing the company’s performance because they do not disclose the needs of a given target market. Take income statement as an example to show the company’s earnings from the sale of services and products, but these figures do not reflect the future need of existing customer. Although the examine company can earn higher revenue than previous year but it do not means it will earn more than competitor in the same basis year. (Mary Jane, 2018)
Accurate Asset and Liability Values – Balance sheet statement is a document include equity, liability and asset. The single property or the debt possibly in assigning the time change, this means that the balance sheet digit not completely is possibly accurate. For example, the value of property will be recorded as the year company bought, meaning the value may lower than anticipated.
Suggestion to make financial statement analysis more objective
There are few method to develop an effective analysis of financial statements. First, identify the industry economic characteristics. Analyst can use the Porter’s Five Forces or analysis to determine a value chain analysis for the industry.
Next, identify company strategies. Analyse a company should not only go for number, part should include can be the nature of the product being offered. Details need to focus on uniqueness of product and supply chain.
Third, assess the quality of the firm’s financial statements. There are three main technique in the assessing financial statement which are recognition, valuation and classification. These technique should use to examine the financial statement to sure the statement complete representation of the firm’s economic position. (Dubos J. Masson, PhD, CTP, FP&A 2018)
Furthermore, analyse the current profitability and risk. The most common analytical tools are the key financial statement ratios. On the context of profitability, shareholder always ask whether the company management how to turn the asset to generate more profit. It is important to learn how to disaggregate return measures into primary impact factors.
Besides, prepare forecasted financial statements. Prediction of the future impact factor is important, even though it is quite challenging but reasonable assumptions is necessary.
Lastly, value the firm. The most common method is DDM. However cash flow may more favourable to short term investor because there is a methodology – “cash is king” in the market. Company with enough cash possess the ability to prevent liquidity problem and generate more cash.
Accounting Tools, 2018. ‘Limitations of financial statements’. Viewed on 7 November 2018.
Mary Jane, 2018. ‘Limitations of Using Financial Statements to Analyse Performance’. Viewed on 8 November 2018.<https://smallbusiness.chron.com/limitations-using-financial-statements-analyze-performance-24471.html>
Dubos J. Masson, PhD, CTP, FP&A, 2018. ‘6 Steps to an Effective Financial Statement Analysis’ Viewed on 9 November 2018.