What Are the Limitations of Income Statements?

Looking at a company's financial statements provides investors an indication of how the company is performing and where it ranks compared to its competitors. It may be the next best thing to sitting in the boardroom, warehouse or manufacturing plant. The income statement shows investors how much the company earned in a given period. However, a company's income statement by itself does not provide the full picture. Furthermore, companies can manipulate earnings.

Income Statement

The income statement, or profit and loss statement, shows a company's net earnings after taking into consideration income less expense. Successful companies post above-average income on a consistent basis, or at least often enough to keep investors satisfied. However, the income statement only tells part of the story of what's going on with the company. To get a full picture, an investor should review other financial statements, such as the balance sheet, cash flow statement, statement of retained earnings and company memos and footnotes.

Manipulating Earnings

A publicly traded company has incentive to post strong earnings. Higher income usually means a higher share price. In some cases, management may feel pressured to make the company appear healthier than it is. For example, a company can boost sales by recognizing sales earlier than what is acceptable. In another example, a company may depreciate its assets longer, thereby recording lower depreciation expense (a non-cash item) to lower its expense base. A company has many ways in which it can inflate its earnings, forcing investors to become financial detectives. Financial analysts must make constant adjustments to "normalize" a company's earnings. Companies report their financial results as required by the Securities and Exchange Commission (SEC), but investors don't know what a company's income statement reveals in the interim.

Financial Ratios

Financial analysis is the process of using a company's financial statements to determine its operating efficiency. Simply using the income statement won't allow you to understand the other relationships that exist between a company's income components and other aspects of the business. Financial ratio analysis uses different parts of the income statement, balance sheet and cash flow statement to make assessments of performance. For example, operating margin -- which is operating income divided by sales -- solely uses the income statement. However, the inventory turnover ratio uses both the income statement and balance sheet (cost of goods sold divided by average inventory).

Peer Review and Comparison

You should never view a company's income statement for just one period of time. Rather, you should compare income statements over time to detect any unusual trends, such as spikes in various line items that appear in the income statement. You must compare a company's financial performance with that of its competitors. You can compare financial ratios to a peer group to make an assessment of whether the company is performing on par, above or below its competition. This way, you can make a more informed decision about whether to invest in the company.

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