What Are the Limitations of Financial Analysis?

The main limitations of financial analysis generally spring from the inability of analysis to account for certain intangible qualities that a company may possess. These qualities may be the result of the structure of the company itself or they could be due to circumstances within the industry in which the company competes. In addition, other limitations of financial analysis are its inability to definitively predict future success based on past financial results. For those reasons, financial analysis should include a healthy dose of contemplative study in addition to simply crunching numbers.

Many people want to know about the securities in which they intend to invest. To accomplish this, they may pore over financial reports and balance sheets to find pertinent nuggets of information revealing a company's strength or lack thereof. While this kind of diligence is certainly helpful in choosing how to invest, it isn't a surefire path to success. There are many limitations of financial analysis which an investor should understand, many of which are tied into the inherent risk involved with investing.

While income reports and balance sheets are indeed solid indications of how a company is performing or has performed in the past, the analytical gaps they leave highlight the limitations of financial analysis. A company that has struggled in the past could hire a new CEO that has a track record of turning troubled firms around. By contrast, a seemingly solid company could actually be headed for a downward spiral based on production problems in the country of its suppliers. Such intangibles wouldn't show up on financial reports, but could be good indicators of future results.

Some investors take the raw financial data they receive and turn them into financial ratios, which are meant to shed light on all of the important aspects of financial operations. But even these ratios can come up short due to the limitations of financial analysis. A company that is just starting out may have a high debt ratio due to large borrowings necessary to kick-start its operations. By contrast, a company with ratios that show high amounts of excess capital might actually be harming itself by not investing that capital properly. These examples prove that even intricate ratios aren't foolproof.

Ultimately, the most obvious limitations of financial analysis are those that deal with its inability to predict the future. No amount of information on past performance can determine, with absolutely certainty, how a company will do in time to come. Sudden real-world events or even some sort of unforeseen internal event within a company can change fortunes overnight. Investors who best understand these limitations are the best prepared to dealing with the unexpected events which affect possible investments.