Significance of Financial Statement Analysis

Financial statement analysis is a crucial tool used by investors, creditors, and other stakeholders to assess the financial health and performance of a company. It provides valuable information that helps in decision-making processes. However, it is important to note that financial statements do not reflect the change in price level, and this has significant implications.

1. Inflation and Purchasing Power
Financial statements are prepared based on historical costs, which do not take into account changes in the price level over time. Inflation erodes the purchasing power of money, and as a result, the values reported in financial statements may not accurately represent the economic reality. For example, the cost of inventory or fixed assets recorded in the financial statements may not reflect their current market value due to the impact of inflation.

2. Comparability
The absence of the consideration of changes in the price level makes it difficult to compare financial statements of different periods. As inflation affects the value of money, comparing financial statements from different periods may not provide an accurate picture of the company's performance. Adjustments for inflation are necessary to maintain consistency and allow for meaningful comparisons.

3. Misleading Ratios and Analysis
Financial ratios are commonly used to analyze the performance and profitability of a company. However, when financial statements are not adjusted for changes in the price level, these ratios may be misleading. For example, a company's profit margin may appear to be improving, but it could be solely due to inflationary factors rather than operational efficiency.

4. Impact on Decision Making
The failure to consider changes in the price level can have a significant impact on decision making. Investors may make incorrect investment decisions, creditors may misjudge the creditworthiness of a company, and management may not have accurate information for planning and control purposes. Considering the impact of inflation is crucial for making informed decisions.

5. Importance of Supplementary Information
To overcome the limitations of financial statements, supplementary information is often provided. This can include disclosures about the impact of inflation or adjusted financial statements that reflect changes in the price level. This supplementary information helps users of financial statements to better understand and interpret the financial performance and position of a company.

In conclusion, while financial statement analysis provides valuable insights into a company's financial performance, it is essential to recognize that they do not reflect changes in the price level. Adjustments for inflation are necessary to ensure comparability, accuracy, and meaningful analysis. Supplementary information that considers the impact of inflation is crucial for making informed decisions based on financial statements.