Financial statements are the mirrors of a business. There are various tools for financial statement analysis. Financial statement analysis helps the reader to understand the over performance of the business and its state of condition on a given date.
However, one must remember that financial statement analysis is not the ultimate truth when it comes to comprehending the business performance. Following are some of the issues, rather shortcomings, which cannot be ignored when it comes to financial statement analysis:-
- Lack of theoretical structure: – There is no sound theoretical base for financial statement analysis. For example, in case of ratios, different authors and experts recommend to look at different numbers for calculating the same ratio. The subjective element in a financial statement analysis is quite vivid. Moreover, there are hundreds of possible interpretations of one single ratio. All this makes the financial statement analysis extremely vague and indeterminate.
- Window-dressing:- Window dressing refers to projecting very attractive numbers in the balance sheet. For example, a company may follow an ambiguous policy of capitalizing certain revenue expenditures. This will immediately inflate the profits. However, if the analyst goes into the details, he will observe that due to faulty policy application of the company, many of the expenditures have not been booked in the revenue statement.
- Grand Companies: – Financial statement analysis works fine with companies which operate in a small-scale environment and belong to one single industry. This is due to availability of concise benchmarks for the particular industry. But there are many huge corporations and group companies which operate in several different industries. Owing to this diversity, systematic benchmarking is not possible due to which financial statement analysis begin to show up as a failed exercise.
- Inflationary/Deflationary Trends:- Cost concept is one of the well known accounting conventions followed globally. Due to this convention, most of the items appearing in the balance sheet are at cost. Due to this, they do not reflect the current economic realities. The purchasing power of the currency may have increased or decreased ever since the date on which a particular transaction was booked. The effects of these changes do not get reflected in the financial statements. Hence the financial statement analysis never show the ‘real life’ position of the business.
- Inconsistent accounting policies: Many times it may happen that the business is not regular in following its accounting policies consistently. Inconsistencies happen in inventory valuation, providing of depreciation, valuation of investments, fixed assets etc, recording of employee and retirement benefits, segmental reporting etc. Due to these inconsistencies, comparison of financial statements over a period of time becomes incomparable. They begin to provide a distorted picture from which no reasonable conclusions can be drawn.
- Mutually conflicting interpretations: There may be certain ratios which give mutually conflicting interpretations. Moreover, some ratios are highly correlated with each other. It requires tremendous expertise to bring all these ratios together and analyse a combined effect of all of them.
Most of the shortcomings mentioned above can be minimized after a careful analysis of the business economics and the current market realities which affect the business.
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