What Are the Dangers of Making Decisions Based on Financial Statements?

Accounting Discrepancies

One of the potential problems with putting faith in financial statements is that they may be subject to accounting discrepancies. Although financial statements are required by the Securities Exchange Commission, there are no uniform practices when it comes to some accounting standards. For example, companies can use different methods to calculate pro forma earnings. This can skew how profitable the company looks. A company might appear more profitable than it actually is by calculating the earnings differently.

Another potential problem with making decisions based on financial statements is that you are looking at past information. When investing, past information does not guarantee any future performance. Even if a company has done well in the past, it could potentially do poorly in the future. Any of the information on income statements and balance sheets is from past quarters. Since you do not know what is actually going on within the company, you may evaluate the information in the financial statements incorrectly.

When investors look at financial statements, they often use financial ratios to make comparisons with other companies. For this to work, you have to compare the company to another business in the same industry. If you choose a company that is not substantially like the other business to compare it against, your assumptions could be wrong. You have to choose the right company to which to compare your subject company. Otherwise, you might think that your company is a good investment when it actually is not.

Another potential problem with using financial statements to make investment decisions is that it does not take into consideration market sentiment. Market sentiment is the general feel that traders in the market have about a company. If traders have a negative viewpoint about a company, it could drive the stock price down, even when the fundamentals on the financial statements look solid. The market sentiment could also make a company's stock price higher than what the financial statements would warrant.