Some of the Many Limitations of Financial Statement Analysis
By Steven Kozack and Michael C. Dennis, MBA, CBF

These are some of the limitations of financial analysis that credit managers must be aware of when they are reviewing a customers financial statements:

• Past financial performance, good or bad, is not necessarily an accurate predictor of future performance.

• Financial statements do not tell you about changes in senior management.

• Financial statements do not tell you about the loss of major customers.

• Financial statements do not tell you about the competitive environment in which the company operates.

• Financial statements do not disclose the companys future prospects, or the results of its expenditures on Research and Development, or new product introductions, or new marketing campaigns, or new pricing strategies, or the customers recent decision to enter or exit a particular market segment.

• The more out-of-date a customers financial statements are, the less reliable they are as a risk management tool.

• Without reading the Notes to the financial statements, credit managers cannot get a clear idea of the risk they are evaluating.

• Unaudited statements may or may not follow Generally Accepted Accounting Principles, and if they do not follow GAAP relying on them could be a serious mistake.

• Financial statements can be altered legally by adjusting certain types of reserves.

• Financial results can be improved by reducing or eliminating discretionary expenditures - even if this cost cutting is at the expense of long term growth and profits.

• Foreign financial statements do not follow GAAP. In some cases, local accounting rules are so different from GAAP accounting rules that it is easy to make the wrong decision after reviewing the foreign financial data.

• Unaudited statements may be inaccurate, misleading, or even deliberately fraudulent - and if they seem too good be true, they may be just that.

• To see the big picture, it is necessary to have at least two consecutive periods of financial statements for comparison. Trends will only become apparent this way. The corollary is that it is not enough to know a customers financial weaknesses. It is also important to know whether the customers financial performance is weak but improving or weak and deteriorating.

• Audited statements do not guarantee accuracy.

• Even audited financial statements are subject to a degree of manipulation.

• Off balance sheet financing is lawful, but can have a devastating effect on a customers financial health.

• The fact that a company is publicly traded and its financial statements are readily available does not guarantee that the company in question is financially stable and creditworthy.

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