Problems In Financial Statement Analysis

Financial statement analysis can be a very useful tool for understanding a a firm's performance and condition. However, there are are certain problems and issues encountered in such analysis which call for care, circumspection and judgement about the over all performance of the the particular firm or entity.

Heuristic and intuitive character 

Most of the ratios found in the old and traditional literature on financial statement analysis have been proposed in a heuristic or intuitive fashion. The ratios are often not related logically to a well defined theoretical framework. Instead they have been suggested in a somewhat impressionistic manner. In the absence of a well defined theoretical underpinning, the traditional univariate approach two financial statement analysis seems to be lacking in direction. It appears ad hoc, informal, subjective and somewhat disjointed.

Development of benchmarks 

Many firms, particularly the larger ones, have operations spanning a wide range of industries. Given the diversity of their product lines, it is difficult to find suitable benchmark for evaluating their financial performance and condition. Hence, it appears that meaningful benchmarks maybe available only for firms which have a well defined industry classification. Even for search firms, at least in India, the financial analyst may run into a difficulty. The information is is available only about the industry average and not about the entire dispersion of ratios for various firms in the industry, it may not be possible to draw meaningful inferences.

Window dressing 

Farms made resort to window dressing to project a favourable financial picture. For example, A firm may prepare its balance sheet at a point when its inventory level is very low. As a result, it may appear that the firm has a very comfortable liquidity position and the high turnover of inventories. When window dressing of this kind is suspected, the financial analyst should look at the average level of inventory over a period of time and not the level of inventory at just one point of time.

Price level changes 

Financial accounting, as it is currently practiced in India and most other countries, does not take into account the price level changes. As a result, balance sheet figures are distorted and profits mis reported. Hence, financial statement can be vitiated.

Variations in accounting policies 

Business forms have some latitude in the accounting treatment of items like depreciation, valuation of stocks, research and development expenses, foreign exchange transactions, installment sales, preliminary and preoperative expenses, provision of reserves, and revaluation of assets. Due to diversity of accounting policies found in practice, comparative financial statement analysis may be vitiated.

Interpretation of results 

Though industry averages and other yardsticks are commonly used in financial resource, it is somewhat difficult to judge whether a certain ratio is good or bad. A high current ratio, for example, may indicate a strong liquidity position (something good) or excessive inventories (something bad). Likewise, a high turnover of fixed assets may mean efficient utilisation of plant and machinery or continuous locking of more or less fully depreciated, worn out, and inefficient plant and machinery. 

Another problem in interpretation arises when a firm has some favourable ratios and some unfavourable ratios - and this is rather common. In such a situation, it may be somewhat difficult to form an overall judgement about its financial strength or weakness. Multiple discriminant Analysis, a statistical tools, may be employed to sort out the net effect of several ratios pointing in different directions.