Financial statement analysis can be a very useful tool for understanding a firm’s performance and conditions. However, there are certain problems and issues encountered in such analysis which call for care, circumspection, and Judgment.
Problems in Financial Statement Analysis:
You have to cope with the following while analyzing financial statements:
Lack of an Underlying Theory: The basic problem in financial statement analysis is that there is no theory that tells us which numbers to look at and how to interpret them. In the absence of an underlying theory financial statement analysis appears to be ad hoc informal and subjective. From a negative viewpoint, the most striking aspect of ratio analysis is the absence of an explicit theoretical structure.
As a result the subject of ratio analysis is replete with untested assertions about which ratios should be used and what their proper levels should be.
Conglomerate Firms: Many firms, particularly the large ones, have operations spanning a wide range of industries. Given the diversity of their product lines, it is difficult to find suitable benchmarks for evaluating their financial performance and condition. Hence, it appears that meaningful benchmarks may be available only for firms which have a well defined industry classification.
Window Dressing: Firms may resort to window dressing to project a favorable 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 a 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.
Variations in Accounting Policies: Business firms 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 pre-operative 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 average and other yardsticks are commonly used in financial ratios, 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 asset may mean efficient utilization of plant and machinery or continued flogging of more or less fully depreciated worn, out and inefficient plant and machinery.
Another problem in interpretation arises when a firm has some favorable ratios and some unfavorable ratios and this is rather common. In such a situation, it may be somewhat difficult to form an overall judgment about its financial strength or weakness. Multiple discriminated analysis, a statistical tool, may be employed to sort out the net effect of several ratios pointing in different directions.
Correlation among ratios: Notwithstanding the previous observation, financial ratios of a firm often show a high degree of correlation. This is because several ratios have some common element (sales for example, is used in various turnover ratios) and several items tend to move in harmony because of some common underlying factor. In view of ratio correlations, it is redundant and often confusing to employ a large number of ratios in financial statement analysis. Hence it is necessary to choose a small group of ratios from a large set of ratios. Such a selection requires a good understanding of the meaning and limitations of various ratios and an insight into the economies of the business.