i. Shortcomings of financial statements- most of the analysis is done by analyzing the information in the financial statements. If this information has any limitations, then the analysis will have the same limitations and will not reflect the true status of the business, moreover, personal judgments could be used in preparing the financial statements, meaning the analysis will also be subjective. 11ii. The analysis is based on analyzing past performance of the company and using them to project the future. However, this projection may not be accurate since the future of the business can be affected by so many factors like changes in market conditions and management. 11iii.
Changes in price levels- price changes take place from period to period. Prices are changing at a very high rate and the price level prevailing today may be very different this may affect the validity of the ratios used. When this happens, it becomes difficult to clearly predict the trend in profitability and financial stability of the company. The only option would be adjusting the price levels of different period so that the analysis can reveal accurate comparisons. 11iv.
Lack of standards- there are no standards or rules to determine the ideal ratios. Different companies use different ratios to measure the profitability, liquidity and financial stability. In such a case, it becomes difficult to interpret the ratios. 11v. Several ratios required to make judgments- a single ratio cannot be adequate to make decisions about the performance of the company, therefore, it is important that several ratios be used to enable one to make decisions. When the ratios become so many, they may confuse the analyst, instead of assisting them to make the correct decision. 11vi.
Problem of comparisons- firms operate in different industries and the same ratios cannot be used to compare all companies. Moreover, even firms in the same industry differ in size, structures and the accounting procedures; therefore, it becomes hard to compare even firms in the same industry. Different firms can as well manipulate their operations and accounting information to portray a good performance, which may not be true. 12vii. The information used in the financial statements maybe out of date. The items of balance sheet are recorded at historical costs, which is not very good for making decisions.
The ratios will therefore reveal the past performance, but predicting the future will be difficult since most parameters change with time. 12Additional information needed. 12i. To deal with the problem of price changes, it is important to consider the current price levels and converting the historical data into the current price levels. 12ii. It is to compare the performance of the firm with others is the same industry, with the same structure and accounting policies and of the same size. 12iii.
It is also important to use a variety of ratios so that the analyst will get to a clear analysis and comparison of the company. 12iv. It is also important to use information from other finance statements like books of original entry so that any problems in the balance sheet and income statement can be addressed. 12