Explain the bases for comparison and the limitations of financial statement analysis?

Question

Explain the bases for comparison and the limitations of financial statement analysis?

Answer 1

Financial statement analysis is used to identify the trends and relationships between financial statement items. Both internal management and external users (such as analysts, creditors, and investors) of the financial statements need to evaluate a company's profitability, liquidity, and solvency. The most common methods used for financial statement analysis are trend analysis, common-size statements, and ratio analysis. These methods include calculations and comparisons of the results to historical company data, competitors, or industry averages to determine the relative strength and performance of the company being analyzed.

Financial Statement Analysis Limitations

Many things can impact the calculation of ratios and make comparisons difficult. The limitations include:

- The use of estimates in allocating costs to each period. The ratios will be as accurate as the estimates.

- The cost principle is used to prepare financial statements. Financial data is not adjusted for price changes or inflation/deflation.

- Companies have a choice of accounting methods (for example, inventory LIFO vs FIFO and depreciation methods). These differences impact ratios and make it difficult to compare companies using different methods.

- Companies may have different fiscal year ends making comparison difficult if the industry is cyclical.

- Diversified companies are difficult to classify for comparison purposes.

- Financial statement analysis does not provide answers to all the users' questions. In fact, it usually generates more questions!

Answer 2

Boy, that's a big question.  Books have been written on the subject.  :D

A few quick things I look for in terms of internal analysis:

Major changes in the profit/loss statement compared to earlier periods.  Why is that type of income up (or down) so much?  Why are we paying so much more for telecommunications?  Etc.

From the balance sheet: Return on equity increasing or decreasing?  Quick ratio?  (In other words, is the company solvent.)  How's the amount of leverage compare to other companies in the industry?

Limitations: just looking at the financials won't tell you the overall trend of the industry or how large a "moat" the company has.  And while it might give hints of things like customer satisfaction, management effectiveness, etc. it won't tell the whole story.