Some of the advantages of financial statement analysis are:
1. Based on financial statement analysis of a firm, investors may make investing decisions pertaining to the firm.
2. Various regulatory authorities like SEBI, IASB, etc. may analysis financial statements of the firm to ascertain whether the firm in following accounting and financial reporting standards required by the statute.
3. Financial statement analysis may be useful to determine corporate tax owed by the firm.
4. Financial statement analysis may be used for comparing performance of the firm over a period of time.
1.1.7 Limitations of Financial Statement Analysis:
Some limitations of financial statement analysis are as follows:
1. Comparability between periods:
An important pre-requisite for financial statements of a firm to be comparable across two time periods is consistency in accounting and reporting standards across the two time periods. If the firm changes its financial and reporting standards across two time periods, the financial statements of the firm for the two time periods may not be comparable. Results may differ as the same financial headings may account for different expenses/income for the two time periods. For example, an expense may appear in the cost of goods sold account in one period, while the same may be a part of administrative expenses in another period.
2. Comparability between firms:
To compare or benchmark a firm with respect to one or more other firms of the industry, various financial ratios of the respective firms are used. However, each firm may aggregate its financial information in a different manner. Due to this, the financial ratios of the various firms may not be comparable with one another. Thus, incorrect conclusions may be drawn if such incomparable financial ratios are used for comparing or benchmarking the firms.
3. Improper use of financial statements for operational analysis:
Financial statements contain financial information pertaining to a firm. Though, financial statements do contain information indicative of certain operational performance areas (e.g., operating assets turnover ratio (ratio of revenue from operations to average operating assets)), however, financial statements may not present a complete picture of the firm’s operational performance. For example, various key indicators of future operational performance such as, size of backlog orders, changes in warranty claims, etc., are not present in financial statements. Thus, analysis of financial statements alone may not present a holistic picture of the operational performance of the firm.