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Limitations Of Financial Analysis
Financial analysis is also considered to be a helpful tool to correctly analyze the condition of the business by many analysts. Since financial analysis is performed according to set mathematical standards, many analysts argue that it helps to minimize human errors to a large extent.
Financial analysis is also dependent on information that is collected from accounting books. So, many analysts believe that it represents true outcomes that may have occurred even if the business policies were followed without actually performing business. Hence, the real outcomes of virtual policies can be obtained from financial analysis.
Meaning of Financial Analysis
The process of analyzing and reviewing a company’s financial statements to make better and smarter economic decisions is called the analysis of financial statements. In other words, the process of finding the financial strengths and weaknesses of a business entity by establishing the financial and strategic relationship between the items of the profit and loss account, balance sheet, and other financial statements is known as financial analysis.
The term ‘analysis’ means the simplification of financial data by methodical classification of the data taken from the financial statements, and ‘interpretation’ means, ‘explaining the reference and significance of the chosen data so simplified.’ Therefore, both’ analysis and interpretation’ are intertwined and complementary to each other.
Disadvantages of Financial Analysis
However, whatever the advantages of financial analysis, it is not free from drawbacks. Here are some major drawbacks of financial analysis that must be considered before starting the financial analysis of a firm’s performance.
Financial analysis does not consider the price level changes: Companies often fail to consider the price level changes when they pertain to financial analysis. They just bring data from various time periods so that data can be compared and analyzed for a given set of checks and tests. This import of data fails to regard the prices vis-a-vis the time. So, it fails to implement the time value of money.
Apart from the time value of money, the transfer of data irrespective of time is related to inflation and deflation, whichever is applicable. This means that financial analysis does not consider whether inflation or deflation was present when the past data was collected and recorded.
Value of intangible assets is ignored: Financial analysis is just a test containing data. It is not related to anything intangible. However, in real, intangible assets can have great value. In fact, for some firms, intangible asset value is more than tangible assets. In financial analysis expenditures made to create intangible assets are charged to expense immediately. This is the wrong way to value intangible assets.
In the case of financial analysis, companies considered only the monetary aspects of a business. Non-monetary facets of the business are usually ignored in the case of financial analysis.
The financial reports and statements cannot provide any solid information about the future. That is, by having the financial analysis done, you cannot surely claim anything about the business that will happen in the future.
The preparation of financial statements which are the backbone of financial analysis is an ongoing concept. It does not help in representing the current position of the firm for which the financial analysis is being prepared.
Objectives of Financial Analysis
Some of the major objectives of financial analysis are:
Reviewing the performance of a company over the past periods: Past performance is used as a precursor to future performance. Financial analysis can reveal the past performance of a company. To check past performance, the trend of past sales, cash flows, return on investment, profitability, debt-equity structure, operating expenses, etc., can be reviewed.
Checking the current position & operational efficiency: Financial analysis can let a company examine the current profitability & operational efficiency. This can lead to an assessment of the enterprise’s financial health. For making long-term decisions, one can review the assets and liabilities of a company. The financial analysis is also helpful in determining the earning capability and operational status of the company.
Predicting growth and profitability prospects: The top management of the firms is concerned with their future prospects. Financial analysis helps the management in reviewing investment decisions of the past and looking for alternatives. This can help in judging the earning potential of the company. With the help of financial analysis, assessment and/or prediction of a potential bankruptcy and probability of failure of a business can be done.
Loan Decision by Financial Institutions and Banks: Financial analysis helps banks, loan agencies, and financial institutions to decide whether a company is fit for getting a loan. The credit risk, terms, and conditions of a loan, interest rate, maturity date, etc. can be decided depending on results obtained from financial analysis to determine the terms of the loan.
There are some significant limitations of financial analysis which are the following:
The financial analysis does not consider cost-price level changes
The financial analysis is ambiguous if the prior knowledge of the changes in accounting procedure followed by the company is not known
Financial analysis is just a study of reports of the enterprise. It does not provide information on other aspects of the business.
Monetary data alone is considered in financial analysis; non-monetary factors are overlooked
The financial analyses are outlined on the basis of accounting concept, so, it does not mirror the current position
Financial analyses are an important tool for businesses to judge their strengths and weaknesses. This also helps them in considering the growth and development of the financials. Therefore, they are considered one of the most useful tools by business entities. However, there are some major disadvantages of financial analyses too. Knowing these disadvantages is helpful for business entities to stay on track with profitability.
Q1. Mention some important significance of financial analysis for finance managers.
Ans. Analysis of financial statements helps the finance manager in the:
Assessment of the operational efficiency and effectiveness of the management of the company.
Analysis of the financial strengths and weaknesses and creditworthiness of the company.
Assessment of the types of assets owned by an enterprise and the liabilities due to the enterprise.
Information about the cash position company. How much debt the company has in relation to equity?
Study the reasons for holding stock and debtors held by the company.
Analysis of the current position of financial analysis.
Q2. What is the main objective of financial analysis?
Ans. Analysis of financial statements provides analysts with ideas and information about the financial position and performance of the company. It helps the managers to plan and decide the future policies for the best financial performance of the company. Financial Analysis helps in discerning the earning capacity and operating performance of the firm.
Q3. How does financial analysis help financial institutions to make loan decisions?
Ans. Financial analysis helps banks, loan agencies, and financial institutions to decide whether a loan can be offered to the company or not. The credit risk, terms, and conditions of a loan, interest rate, maturity date, etc. if sanctioned, can be decided depending on results obtained from financial analysis.
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