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The Limitations of Financial Statement Analysis
© 1995 Michael C. Dennis


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:

1. 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  The more out-of-date a customer's financial statements are, the less value they are to the credit department.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. 
2. 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 (see Table 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.