Limitations of Balance Sheet Analysis – Balance Sheet Analysis

Although the ratios reviewed in this section provide a useful starting point for assessing a firm’s financial management policies, several limitations must be considered. First, ratio calculations are only the initial step in analyzing a firm’s condition. They merely provide the analyst with a point of departure for asking further questions. Second, individual financial statements such as the balance sheet are seldom analyzed separately from other statements described in the next two chapters. In fact, many of the most useful ratios used by analysts measure relationships among financial statements, rather than relationships within a single financial statement. For this reason, we will expand and enrich our study of ratio analysis after first describing the other primary financial statements. Third, information useful for analyzing and clarifying financial statements is contained in other parts of a company’s financial reports.

An important limitation in comparing financial ratios across firms is the fact that their accounting methods may differ. Later chapters discuss the varieties of different methods that firms may use in measuring assets, liabilities, shareholders’ equity, revenues, and expenses. For now, be aware that financial ratios may be significantly affected by alternative accounting methods. The analyst attempts to adjust for differences caused by accounting methods in order to make valid ratio comparisons among different firms. The notes to the financial statements alert the analyst to the principal methods being used.

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