Recently I have read an article called “Limitations of financial statement analysis” and I felt a strong desire to comment on some questions raised in it. Not to be proofless I will provide you with quotations from that article and my explanations why they are misleading.
1. “Financial statement analysis is based on past data …(and that’s why) it cannot provide a basis for future … planning”. Imagine your car was going 67 mph three seconds ago, 68 mph two seconds ago and 69 mph one second ago. What is its current speed? The same example can be applied to any business. If the company's management was able to make a firm sustainable in the past, one may expect it to be sustainable in the future. If a driver sees a reindeer on the road the car will start rapidly losing speed. The same can be said about the company: the external circumstance can influence its financial indicators in the future. But the retrospective data is a basis for the future prediction. The forecasting rarely gives a 100% precise result but one rule can always be applied: the more stable economy’s, industry’s and company’s conditions are, the more you can trust results based on the past experience.
2. “Problem in comparability” . The author argues that the financial statement analysis is inaccurate because normative indicators for different-sized companies are different. This raises a question: is there book or handbook in financial statement analysis that doesn’t state that the analyst may only compare the financial ratios of companies with similar size and within one industry?
3. “Reliability of figures” . The author says that the financial data can be wrong and incorrect. Well, this is why the financial audit is so important. The main goal of the process is to check if the data is relevant and correct. An auditor is like a journalist or a scientist. If he makes one serious mistake he will be ‘dead’ as a specialist. An auditor needs years to earn a good reputation and no one wants to risk by verifying an inaccurate financial statement. You may say that an auditor is not checking 100% of information in the financial statement. But it’s his duty to determine the most risky areas that may contain mistakes or data manipulations.
4. Various methods of Accounting and Financing” and “Change in Accounting Methods”. That is exactly why you need to use a financial statement disclosure. This part contains all the important information, so that one could make a weighed conclusion about the company’s financial condition and financial effectiveness.
5. “Changes in the Value of Money”. The author argues that the financial statement analysis is inaccurate because the money is losing its purchasing power. But methods of measuring the change in the value of money are well known. The inflation during the period under review should always be taken into account.