Limitations of Balance Sheet

There is no doubt that every business prepares balance sheet at the

end of each accounting period yet it suffers from the following
limitations:
• Some of the current assets are valued on estimated basis, so the
Balance sheet is not in a position to reflect the true financial
position of the business.
• Fixed assets are shown in the Balance sheet at original cost
less depreciation up-to-date. Thus Balance sheet does not
show true value of assets.
• Balance sheet can not reflect those assets which cannot be
expressed in monetary terms such as skill, honesty and loyalty
of workers.
• Intangible assets like goodwill are shown in the Balance Sheet at
imaginary figures which may bear no relationship to the market
value.

The limitations of financial statement analysis.

Financial statement analysis is a tool most credit managers use in
evaluating credit risk. Credit risk comes in two basic forms:
1. The risk that a customer's business will fail resulting in bad debt
write offs for its creditors, and
2. The risk that the customer will pay slowly.
However, many credit managers perform financial statement analysis
without understanding its limitations. These are some of the limiting
factors credit managers must keep in mind:
* Past financial performance, good or bad, is not necessarily a good
predictor of what will happen with a customer in the future.
* The more out-of-date a customer's financial statements are, the less
value they are to the credit department.
* Without the notes to the financial statements, credit managers
cannot get a clear picture of the scope of the credit risk they are
considering.
* Unless the customer financial statements are audited, there is no
assurance they conform to generally accepted accounting principles.
As a result, the statements may be misleading or even completely
fraudulent.
* To see the big picture, it is necessary to have at least three years of
financial statements for comparison. Trends will only become
apparent through comparative analysis.
In performing liquidity analysis, most credit managers use the current
and/or quick ratio. The problem is that these two ratios only provide
an estimate of a customer's liquidity - they are not accurate enough to
be used to predict whether or not a customer is capable of paying
trade creditors and your company in particular - on time.
Table 1
Hypothetical Customer Balance Sheet
Cash $ 200 Accounts Payable $ 100
A/R $ 500 Current portion of long-
Inventory $ 300 term debt $ 200
Total Current Assets $1,000 Current liabilities $ 300
Fixed Assets $1,000 Long-term debt $ 700
Total Assets $1,000 Equity $1,000
$2,000 Total debt + equity $2,000
Ratio Analysis
Current ratio 3.33 to 1
Quick ratio 2.33 to 1
Debt to equity ratio 1.00 to 1
A "standard" evaluation of liquidity using the current ratio and the
quick ratio would indicate the customer in Table 1 has strong
liquidity. In reality, this may or may not be the case. For example:
If the current portion of the long term debt were due before the A/R
can be converted into cash, this customer could have a cash flow
problem and might be unable to pay trade creditors.
This information is not available through standard ratio or financial
statement analysis.
However, our hypothetical customer may have already taken steps to
address this short-term liquidity problem. The customer might have
arranged for a loan to factor its receivables. Unfortunately, this type
of information is also not available or apparent using normal financial
ratio analysis. Therefore, credit managers must ask more questions
and to understand the terms their customer is giving to its customers
as well as the terms it receives from its suppliers.
Referring back to Table 1, traditional ratio analysis would also
suggest that because our hypothetical company has debt-to-equity
ratio of 1 to 1 and is not highly leveraged, that the customer is a
relatively good credit risk. This is not necessarily the case. Consider
this example:
Assume a formidable, well-financed competitor, with a superior
product, has just entered the marketplace. The fact that your customer
is not highly leveraged does not necessarily mean your customer will
remain profitable and viable, assume your customer is embroiled in a
lawsuit involving product liability claims, environmental cleanup
issues, deceptive advertising, or securities fraud. These are contingent
liabilities. Contingent liabilities do not appear on the balance sheet.
The moral is that just because a customer has a strong balance sheet
does not mean selling to this customer on an open account is low risk.
Referring back to the balance sheet in Table 1, let's assume your
customer is the wholly owned subsidiary of another company.
Suppose your customer's parent company is having financial
difficulties, or is embroiled in a lawsuit involving large contingent
liabilities. If the parent company decides to file for bankruptcy
protection, in most cases its subsidiaries will also file at the same
time. Again, traditional financial analysis does not give a clear picture
of the risk involved in selling on an open account basis in this case.
Even if the parent company is not considering filing for bankruptcy
protection, the parent company could require its subsidiaries to
upstream cash to the detriment of the suppliers of the subsidiary.
Another possible problem not defined or described in financial
statement analysis is that the due date on bank debt can be accelerated
if the debtor fails to meet a loan covenant. If we assume our
hypothetical customer is out of covenant now, the risk of business
failure and bad-debt losses is unrelated to the insights and information
gained through financial statement analysis.
Here are a few ideas about financial statement analysis to keep in
mind. As a customer's open account credit needs continue to grow, at
some point it will become necessary to receive and evaluate a
customer's financial statements to make an intelligent and informed
decision about whether or not to extend the customer more open
account credit. Once you have begun this process, be certain to
request or require periodic updates.
The bigger your concern, the more frequently you should review a
customer's financial statements. Pay particular attention to the nature
and scope of the audit performed on a customer's financial statements.
Remember that internally prepared financial statements might not be
worth the paper they're printed on. Be aware there is a limitation to
comparing a customer's financial ratios to an industry norm. The
limitation is the fact that industry norms are derived from companies
willing or required to share financial information. Therefore, the best
source of this information is publicly traded companies. So, if you're
comparing a small, privately held customer's ratio to a public
company's, the small company often suffers by comparison.
Keep in mind the fact that financial statement analysis is just one
factor credit managers use to evaluate risk. Despite its limitations, this
type of analysis has an important role in helping credit managers to
gauge and control risk.

What are the limitations of financial

statements?
Financial statements are based on historical costs and as such the
impact of price level changes is completely ignored. They are interim
reports. The basic nature of financial statements is historic. These
statements are neither complete nor exact. They reflect only monetary
transactions of a business. The following limitations may be noted:
1. The financial position of a business concern is affected by several
factors-economic, social and financial, but financial factors are being
recorded in these financial statements. Economic and social factors
are left out. Thus the financial position disclosed by these statements
is not correct and accurate.
2. The profit revealed by the Profit and Loss Account and the
financial position disclosed by the Balance Sheet cannot be exact.
They are essentially interim reports.
3. Facts which have not been recorded in the financial books are not
depicted in the financial statement. Only quantitative factors are taken
into account. But qualitative factors such as reputation and prestige of
the business with the public, the efficiency and loyalty of its
employees, integrity of management etc. do not appear in the
financial statement.
4. The rupee of 1995, as for example, does not mean the same as the
rupee of 2010. The existing historical accounting is based on the
assumption that the value of monetary unit, say rupee, remains
constant and accordingly assets are recorded by the business at the
price at which they are required and the liabilities are recorded at the
amounts at which they are contracted for. But monetary unit is never
stable under inflationary condition. This instability has resulted in a
number of distortions in the financial statements and is the most
serious limitation of historical accounting.
5. Many items are left to the personal judgement of the accountant.
For example; provision of depreciation, stock valuation, bad debts
provision etc. depend on the personal judgement of accountant.
6. On account of convention of conservation the income statement
may not disclose true income of the business since probable losses are
considered while probable incomes are ignored.
7. The fixed assets are shown at cost less depreciation on the basis of
"going concern concept" (one of the accounting concept). But the
value placed on the fixed assets may not be the same which may be
realized on their sale.
8. The data contained in the financial statements are dumb; they do
not speak themselves.
The human judgement is always involved in the interpretation of
statement. It is the analyst or user who provides tongue to those data
and make them to speak.

What are the disadvantages of a profit and loss account?

A. Cost allocations are based on estimates which makes the data subjective.

B. The various choices of accounting methods (for inventory valuation, depreciation

methods, etc.) make evaluation and comparison of different companies difficult.

C. Different companies may have different fiscal year ends also making comparisons
difficult.

D. Financial data is not adjusted for price changes, replacement cost values,
inflation/deflation issues, etc.