Question

Explain the limitations of analysis of financial statements.

Answer 1

Although analysis of financial statement is essential to obtain relevant information for making several decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from a number of the following limitations.

1. Mislead the user :

The accuracy of financial information largely depends on how accurately financial statements are prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong which may mislead the user in making decisions.

2. Not useful for planning :

Since financial statements are prepared by using historical financial data, therefore, the information derived from such statements may not be effective in corporate planning, if the previous situation does not prevail.

3. Qualitative aspects :

Then financial statement analysis provides only quantitative information about the company's financial affairs. However, it fails to provide qualitative information such as management labor relation, customer's satisfaction, management's skills and so on which are also equally important for decision making.

4. Comparison not possible :

The financial statements are based on historical data. Therefore comparative analysis of financial statements of different years can not be done as inflation distorts the view presented by the statements of different years.

5. Wrong judgement

The skills used in the analysis without adequate knowledge of the subject matter may lead to negative direction . Similarly, biased attitude of the analyst may also lead to wrong judgement and conclusion.

The limitations mentioned above about financial statement analysis make it clear that the analysis is a means to an end and not an end to itself. The users and analysts must understand the limitations before analyzing the financial statements of the company.