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Myths About Financial Statement Analysis

There are any number of myths and misconceptions about financial statements and financial statement analysis. Here are a few of them:

Myth: Financial analysis stands alone in its ability to evaluate risk. Reality: Financial statement analysis is one tool in the analyst's toolbox that can be used to measure and monitor risk.

Myth: Asking for a financial statement is asking for trouble. Reality: Analysts will not always get financial statements from privately held companies, but doing so is becoming a routine part of any interaction between applicant and credit grantor.

Myth: Credit reporting agency reports do a good job reporting on customers' financial statements. Reality: Statements are often out of date. Credit reporting agencies tend to truncate (shorten) the information received. Agencies do not normally provide the Statement of Cash Flows, or Notes as part of their analysis.

Myth: Financial statements should be compared to industry norms to give credit managers a benchmark. Reality: Industry norms are often unrepresentative of the "normal" performance of the majority of companies in an industry. The flaw lies in the way data is collected.

Myth: The choice of method of depreciation is a minor detail of little concern to the credit manager. Reality: All of the accounting conventions adopted by the debtor are important in learning about the customer or applicant's financial stresses.

Myth: Foreign financial statements easy to get and easy to understand. Reality: In some countries, trade creditors are almost never given financial statements. Foreign financial statements are hard to interpret because they:

Are not denominated in US dollars,
Are not formatted in the same way as US financial statements,
Classify accounts differently,
Do not follow GAAP,
May have little or nothing in common with the customer's true financial condition,
Tell creditors nothing about the customer's ability to get payments out of the country and into the account of the foreign seller.

Myth: A customer with a current ratio if less than 2 to 1 is an accident waiting to happen. The customer is at serious risk of being unable to retire debts as they come due. Reality: Many companies operate successfully with tight current ratios - especially if these companies have made arrangements allowing the company to borrow short term to meet its current obligations.

Myth: A strong current ratio means the company under review is highly liquid and will pay debts as they mature. Reality: It is possible for a customer to have a strong current ratio, but be unable to pay creditors. It is a question of timing. If liabilities come due before assets can be converted into cash the company may be in trouble. Also, because a company has the ability or the cash to pay its creditors on time does not mean the customer will do so.

Myth: The quick ratio [or acid test ratio] is a good way to measure a customer's liquidity. Reality: The quick ratio is a more sensitive measure of liquidity than the current ratio. A strong quick ratio does not guarantee that a customer can and will pay creditors' bills as they come due.