Limitations of Financial Statement Analysis

A point to consider is that financial statements reflect past history. Balance sheets only represent the relationship between assets and liabilities on a specific day in the past. An income statement or the statement of cash flow reflects changes over a specified period of time. Credit professionals analyzing the financial statements must remember significant changes can impact a company's financial standing after the financial information is compiled and published. Examples can include death of an officer, loss of a major customer, expiration of a patent. On the positive side, examples can include loss of a major competitor, success of a recent product innovation, infusion of additional capital, or the hiring of a very talented employee.

Some point to consider:

• Past performance (good or bad) is not a perfect indicator of future performance.
  
• The more out of date a customer's financial statements are, the less valuable they are in evaluating credit risk.
  
• Unaudited financial statements may contain two types of errors: (1) unintentional mistakes, or (2) intentional frauds.
  
• Unless a customer provides prior period financial statements for comparison, there is no starting point that can be used for comparison.
  
• Notes to the financial statements contain information not found anywhere. Without them, but most creditors do not request or receive these notes.
  
• Fixed assets are shown on the balance sheet at their acquisition cost minus accumulated depreciation. The fair market value of these assets is always different from the book value.
  
• No open account sale is guaranteed
  
• Problems in the debtor company can create unexpected problems for the debtor and its creditors.

Edited by Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.