Accounting (9215) | The limitations of financial statements and ratio analysis when assessing business performance

Accounting (9215) Study Notes: Limitations of Financial Statements and Ratio Analysis

Hello future Accountants!

Welcome to a crucial chapter. So far, we've learned how to calculate amazing ratios like Gross Profit Margin and Current Ratio. We know these numbers tell us about performance, liquidity, and efficiency. But here’s the big secret: Numbers don't tell the whole story.

In this chapter, we will look beyond the numbers. We’ll learn the weaknesses (the limitations) of financial statements and ratio analysis. This knowledge helps us give much wiser advice to business owners. Don't worry if this seems tricky; we’ll break down these concepts step-by-step!

Understanding Limitations: Why Financial Figures Aren't Perfect

Imagine you assess a student only by their Maths exam score. You wouldn't know if they are a brilliant artist, a fantastic leader, or terrible at communicating. Financial statements are similar—they only show the "Maths score" (the money) and miss everything else.

The limitations of assessing business performance fall into three main groups:

1. Limitations built into the Financial Statements themselves.
2. Limitations of Ratio Analysis (when making comparisons).
3. The importance of Non-Financial Factors.

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1. Limitations of Financial Statements (The Numbers Problem)

Financial statements (like the Income Statement and Statement of Financial Position) are not pure facts. They are heavily influenced by rules, judgments, and the time they were created. This can make the figures misleading.

A. The Use of Historical Cost

Accounting rules often require assets to be recorded at their historical cost—the price the business originally paid for them.

• The Problem: This cost quickly becomes outdated due to inflation or changes in market value.
• Example: A company bought land 30 years ago for $50,000. It is still shown on the Statement of Financial Position at $50,000, even if its actual market value today is $5 million.
• Key Takeaway: The Statement of Financial Position may not reflect the true, current value of a company's assets.

B. Accounting Estimates and Judgements

Accountants must make estimates about future events. These are educated guesses, not concrete facts, and they heavily impact profit figures.

• Depreciation: Choosing a method (straight-line vs. reducing balance) and estimating the useful life of an asset is a judgment call. Different choices lead to different annual depreciation expenses, directly changing the reported net profit.
• Provision for Doubtful Debts: Predicting how many credit customers won't pay their bills involves judgment. If the accountant is overly optimistic, profit may look higher than it should.

C. Exclusion of Non-Monetary Items

Financial statements only show things that can be measured accurately in money.

• What is missed? The value of staff training, brand reputation, customer satisfaction, or the quality of management.
• Analogy: You can’t put a dollar value on the loyalty of Apple customers, but that loyalty is a massive factor in Apple’s success. Since it can't be put on the Statement of Financial Position, it is ignored by the financial reports.

D. Creative Accounting (Window Dressing)

Businesses want to look good, especially if they are trying to attract investors or secure a loan. Creative accounting (sometimes called window dressing) refers to legal but clever ways businesses manipulate figures just before the year-end to make their financial statements look better.

• Example: Delaying paying major creditors until after the year-end to make the Current Ratio look healthier temporarily.
• Warning: This practice shows that the numbers presented might not represent the business's normal operations.

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2. Limitations of Ratio Analysis (The Context Problem)

Ratio analysis involves calculating percentages and then comparing them. The comparison part is where we find significant limitations.

A. Different Accounting Policies

If you compare two companies (Company A and Company B), their ratios may be different simply because they use different accounting methods.

• If Company A uses the Reducing Balance method for depreciation and Company B uses Straight-Line, their reported Net Profit figures will be different, making their Profitability Ratios incomparable.
• For valid comparison, consistency is key.

B. Economic Factors and Inflation

When comparing a company's ratios over several years (e.g., 2020 vs. 2024), we must remember that prices and the value of money change due to inflation.

• If the Gross Profit Margin increases from 30% in 2020 to 32% in 2024, that might look good. But if general inflation was 10% over that time, the 2% increase in margin might not be a real increase in purchasing power.

C. Industry Differences (Comparing Apples and Oranges)

Ratios are only meaningful when compared to industry averages or competitors in the same field.

• A high Current Ratio (say, 3:1) looks excellent for a manufacturing firm, suggesting strong liquidity.
• The same 3:1 Current Ratio would look very bad for a bank, which is expected to maintain very high liquidity.
• Rule: Never compare the ratios of a service company to a retail company, or a utility company to a tech start-up. They operate in completely different ways.

D. Ratios are Historical (A Snapshot in Time)

Financial statements are usually prepared only once a year, showing the position and performance at the end of that period.

• A ratio gives you a "snapshot" of the business. It ignores major events that happened the day after the statements were finalized (e.g., a massive machine broke down, or a competitor went bankrupt).
• Investors need to look at more recent, internal reports, not just the annual financial statements.

Did you know?

If a company dramatically sells off inventory right before the year-end deadline, it looks like their inventory turnover is fast. This temporary action is purely for "show" and doesn't reflect the usual rate of sales.

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3. The Importance of Non-Financial Factors

The smartest business assessment always combines financial figures (ratios) with non-financial factors. These factors often determine a company's future success much more than its current profit margin.

A. Quality of Management and Leadership

Financial statements cannot measure how smart, experienced, or ethical a company's leaders are. Poor management can quickly ruin a profitable company.

• What to look for: Are managers planning effectively? Are they innovating? Do they treat staff well?

B. Staff Morale, Skills, and Training

Happy and highly-trained employees are more productive, make fewer mistakes, and stay with the company longer (lowering recruitment costs).

• High staff turnover (people quitting frequently) is a sign of deep problems, even if the financial statements currently show a profit. This factor is not measured in dollars on the Income Statement.

C. Market Share and Brand Reputation

Market share is the percentage of total sales in an industry that one company controls. Growing market share shows the business is winning customers and securing its future.

• A strong brand reputation (being known for quality or trustworthiness) means customers are more likely to choose that business, even if its prices are slightly higher. This security is valuable but invisible in the financial ratios.

D. Customer Satisfaction and Loyalty

If customers are unhappy, future sales will drop, eventually hurting profitability. Measuring customer complaints or using surveys is crucial, but these results don't appear in the accounting books.

E. Technological Advancements

Is the business investing in modern technology and processes? Failing to keep up with technology can make a profitable company obsolete very quickly. Assessing the age of equipment and the level of computerisation is vital.

You now understand that Accounting is not just about crunching numbers—it’s about understanding the story those numbers tell, and realizing where the story is incomplete. Well done!