23 Jan What The Financial Statements Are Telling You?
WHY MUST PRODUCE FINANCIAL STATEMENTS?
Some sources say the purpose of the financial statements is to provide information about the results of operations, financial position, and cash flows of an organization, so that this information is used by the readers of financial statements to make decisions regarding the allocation of resources. Other sources say financial statements are important to investors because they can provide information about a company’s revenue, expenses, profitability, total debts, and other sources of funds.
But the above is not the right reason of why a firm must produce financial statements.
A firm brings two groups of people together. Let’s say Henry needs money to start a business, and Charlie has money and is looking around for a good investment opportunity. One day, Henry meets Charlie and Henry convinces Charlie to invest money in his new business. So, Henry forms a new company, appoints himself as the only director of the company. Then, the firm issues equity shares to Charlie, and by investing his money in Henry’s company, Charlie becomes the shareholder.
Now one question arises. Who has the power to run the company? Under the company law, Henry has the power to run the company. Therefore, he can decide how the money in the company is to be used. Whereas Charlie cannot interfere with the day-to-day operations.
Henry has the duty to tell Charlie, the investor, how the company performs, and this is usually in the form of financial statements produced by Henry and the company and presented to Charlie. In another word, Henry has to tell Charlie how the company performs in operations, investing, and financing activities.
Therefore, financial statements are required because the management of the company is accountable to the shareholders on how the money of the company is managed.
The three financial statements produced by the company are:
- Income statement
- Statement of financial position (also called balance sheet)
- Cash flow statement
An income statement can be explained using the following equation:
Profit = Revenues – expenses
When a firm sells products or performs services, revenue is generated. To generate revenue, the firm must buy materials and incur operating expenses. Therefore, the net results of the revenue and expenses are profit.
The profit generated belongs to the shareholders. Dividends can be paid out of the profit, or the firm could retain the profit for re-investment purposes.
More details could be provided here. For example, an income statement can reveal the volume of revenues generated from different products or regions, and the nature of the various types of expenses incurred.
STATEMENT OF FINANCIAL POSITION
It is also called the balance sheet. It is presented in the form of an accounting equation:
Assets = Liabilities + Equity
Essentially, it says:
What assets the company buys = where the funds come from
The purpose of the balance sheet is to inform the reader about the current status of the business as of the date listed on the balance sheet. This information is used to estimate the liquidity, funding, and debt position of an entity.
STATEMENT OF CASH FLOWS
Finally, the purpose of the statement of cash flows is to show the nature of cash receipts and cash disbursements, usually classified into three categories: operating, investing, and financing.
One must know that revenue is not the same as cash inflows. Also, expenses incurred are not the same as cash outflows. This is because the preparation of the income statement and the statement of financial position must follow accounting principles and standards, not the time when the money is received or paid.
Challenges in Analysing business Performance based on Financial Statements
Normally, when reviewed over multiple time periods, the financial statements can also be used to analyze trends in the results of company operations, assets, liabilities, and equity.
But, using only the three financial statements, the user of financial statements could only focus on the bottom lines of financial reporting, i.e. net profit after tax and shareholders’ equity to interpret the firm’s performance.
Users’ decisions in deciding whether to continue to support the company or not are based almost exclusively on publicly available information found in annual reports. Also, focuses primarily on financial statements and does not usually address a company’s products, the economy, interest rates, or other variables that many analysts frequently incorporate.
Moreover, the financial reporting system is not perfect. Economic events and accounting entries do not correspond precisely – they diverge across the dimensions of timing, recognition, and measurement. Analysis of financial statements is further complicated by variations in accounting treatment among companies.
Although there are rules and conventions on how companies should prepare their financial statements, so as to make it easier for users of the financial statements, each company, each business, and each industry are different. Also, managers are given enough flexibility – within the confines of the accounting rules – to make certain assumptions and appropriate judgments with the aim of portraying the underlying economic reality of their respective companies. The accounting discretion granted to managers is potentially risky, because it allows them to manipulate financial numbers in reported financial statements.
For example, many investors view profits as a measure of managers’ performance. some managers may find it an incentive to use their accounting discretion to ‘manage’ reported profits by making assumptions allowed under the accounting standards.
Against this backdrop, it would not be surprising if such accounting frauds are discovered, and investors suffered losses. The Enron case in 2001 and the Toshiba case in 2015 are examples of accounting scandals.
Using accounting ratios can provide a better interpretation of the business performance. Two popularly used ratios return on equity and current ratio.
For example, return on investment, ROI, is popularly used to evaluate the quality of investment decisions made by the top management. The ratio is:
Net profit after tax
Over time, if the number is getting higher, it means the company has been making the right investment decision.
Another accounting ratio, the current ratio, is used to measure the liquidity position of the company. It is calculated as:
Over time, if the number is above 1, it means the company is able to depend on its liquid assets to cover its short-term liabilities, and that the company is a going concern and able to continue operations.
Interpreting Financial Statement Skills
In today’s fast-changing business development, it is very important for the management staff in any organization (private sectors, not for profit organizations, social services providers, etc) to acquire the following skills when interpreting financial statements:
- The structure of the three financial statements
- Essential accounting rules, standards, and principles
- Purpose of auditor’s report
- Accounting ratios to interpret profitability, liquidity, debt burden, and efficiency of a business
To know how to interpret the financial statements, we have created an intensive 1-day workshop on “Understanding Financial Statements” to enable participants to understand different accounting terms and learn how to perform a comprehensive analysis of a business using financial statements.