Importance and Limitations of Financial Statement Analysis

Different users analyse financial statements for different purposes, and the analysis is only as good as the raw statements it works upon — so its usefulness and its limits must both be understood.

Importance / uses of financial statement analysis

• For management — it highlights areas of strength and weakness, so that corrective action can be taken; it is a tool of planning and control.
• For owners and shareholders — it shows the profitability and financial soundness of the business and the return on their investment.
• For lenders (banks and financial institutions) — it reveals the firm's liquidity and long-term solvency, and hence its capacity to service and repay debt.
• For creditors and suppliers — it helps them judge whether the firm can pay for goods supplied on credit within a reasonable time.
• For prospective investors — it helps them compare firms and choose where to invest.
• For employees — it gives an idea of the firm's stability and its ability to pay wages and bonuses.
• For the government and regulators — it assists in taxation, price regulation and the framing of policy.

Limitations of financial statement analysis

• It is only as reliable as the statements analysed. If the underlying financial statements are themselves inaccurate, window-dressed or based on questionable estimates, the analysis built on them will be misleading — 'garbage in, garbage out'.
• It ignores price-level changes. Because the statements are at historical cost, comparisons across years can be distorted when the general price level has changed materially between those years.
• Different firms use different accounting policies. When two firms depreciate assets or value stock by different methods, an inter-firm comparison of their analysed figures is not strictly like-for-like.
• It is essentially quantitative. It works with figures and cannot capture qualitative factors — the quality of management, labour relations, the firm's reputation — that may matter as much as the numbers.
• It is historical. The analysis explains the past; the future may differ, so past trends must be used for forecasting with caution.
• A single tool can mislead. Any one technique (a lone ratio, a single comparative figure) can give a one-sided impression; sound conclusions need several tools used together and read alongside the surrounding circumstances. …