Important Tips About Financial Statements
FINANCIAL STATEMENTS
Financial statements are written records that convey the financial activities and conditions of a business or entity and consist of four major components. Financial statements are meant to present the financial information of the entity in question as clearly and concisely as possible for both the entity and for readers. Financial statements for businesses usually include income statements, balance sheets, statements of retained earnings and cash flows but may also require additional detailed disclosures depending on the relevant accounting framework. Financial statements are often audited by government agencies, accountants, firms to ensure accuracy and for tax, financing or investing purposes.
Importance Of Financial Statements.
The importance of financial statements lies in their utility to satisfy the varied interest of different categories of parties such as management, creditors, public. The utility of financial statements to different parties are discussed in detail as follows:
Investors:
The investors include both short-term and long-term investors. They are interested in the security of the principal amount of loan and regular interest payments by the concern. The investors will study the long-term solvency of the concern with the help of financial statements. The investors will not only analyze the present financial position but will also study future prospects and expansion plans of the concern. The possibility of paying back the loan amount in the face of liquidation of the concern is also taken into consideration.
Labour
Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations also, the size of profits and profitability achieved are greatly relevant.
Stock Exchange:
The stock exchanges deal in purchase and sale of securities of different companies. The financial statements enable the stock brokers to judge the financial position of different concerns. The fixation of prices for securities, etc., is also based on these statements.
Government:
The financial statements are used to assess tax liability of business enterprises. The government studies economic situation of the country from these statements. These statements enable the government to find out whether business is following various rules and regulations or not. These statements also become a base for framing and amending various laws for the regulation of business.
Management:
The financial statements are useful for assessing the efficiency for different cost centres. The management is able to exercise cost control through these statements. The efficient and inefficient spots are brought to the notice of the management. The management is able to decide the course of action to be adopted in future.
Creditors:
The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. The calculation of current ratio and liquid ratio will enable the creditors to assess the current financial position of the concern in relation to their debts.
Bankers:
The banker is interested to see that the loan amount is secure and the customer is also able to pay the interest regularly. The banker will analyze the balance sheet to determine financial strength of the concern and profit and loss account will also be studied to find out the earning position.
A banker has a large number of customers and it is not possible to supervise their business activities. It is through the financial statements that a banker can keep a watch on the business plans and performances of its customers. These statements also help the banker to determine the amount of securities it will ask from the customers as a cover for the loans.
Trade Associations:
These associations provide service and protection to the members. They may analyze the financial statements for the purpose of providing facilities to these members. They may develop standard ratios and design uniform system of accounts.
Shareholders
Management is separated from ownership in the case of companies. Shareholders cannot, directly, take part in the day-to-day activities of business. However, the results of these activities should be reported to shareholders at the annual general body meeting in the form of financial statements.
These statements enable the shareholders to know about the efficiency and effectiveness of the management and also the earning capacity and financial strength of the company.
Limitations of Financial Statements
The limitations of financial statements are those factors that a user should be aware of before relying on them to an excessive extent. Knowledge of these factors could result in a reduction of invested funds in a business, or actions taken to investigate further. The following are all limitations of financial statements:-
(i) Manipulation or Window Dressing
Some business enterprises resort to manipulate the information contained in the financial statements so as to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing.
(ii) Use of Diverse Procedures
There may be more than one way of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between such enterprises. For example, depreciation can be charged under straight line method or written down value method. However, results provided by comparing the financial statements of such business enterprises would be misleading.
(iii) Qualitative Aspect Ignored
The financial statements incorporate the information which can be expressed in monetary terms. Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For example, a conflict between the marketing manager and sales manager cannot be recorded in the books of accounts due to its non-monetary nature, but it will certainly affect the functioning of the activities adversely and consequently, the profits may suffer.
(iv) Dependence on historical costs.
Financial statements are historical in nature as they record past events and facts. Due to continuous changes in the demand of the product, policies of the firm or government etc, analysis based on past information does not serve any useful purpose and gives only postmortem report.
(v) Price Level Changes
Figures contained in financial statements do not show the effects of changes in the price level, that is price index in one year may differ from price index in other years. As a result, misleading picture may be obtained by making a comparison of figures of past year with current year figures.
(Vi)Not verified.
If the financial statements have not been audited, this means that no one has examined the accounting policies, practices, and controls of the issuer to ensure that it has created accurate financial statements. An audit opinion that accompanies the financial statements is evidence of such a review.
(vii) Subjectivity and Personal Bias
Conclusions drawn from the analysis of figures given in financial statements depend upon the personal ability and knowledge of an analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net profit before tax, while another analyst may take it as net profit after tax.
(viii) Lack of Regular Data/Information:
Analysis of financial statements of a single year has limited uses. The analysis assumes importance only when compared with financial statements, relating to different years or different firm.
(ix) No predictive value.
The information in a set of financial statements provides information about either historical results or the financial status of a business as of a specific date. The statements do not necessarily provide any value in predicting what will happen in the future. For example, a business could report excellent results in one month, and no sales at all in the next month, because a contract on which it was relying has ended.
(X) Not always comparable across companies.
If a user wants to compare the results of different companies, their financial statements are not always comparable, because the entities use different accounting practices. These issues can be located by examining the disclosures that accompany the financial statements.
FINANCIAL STATEMENT TOOLS
There are various tools are used to study the relationship between different statements. An effort is made to use those tools or techniques which clearly analyse the financial position of the enterprise. The following are tools of financial statements:-
COMPARATIVE FINANCIAL STATEMENTS :
The comparative financial statements will provide a compari�son between two stipulated periods for an organisation. It will also provide a comparison for two or more enterprises for one or more accounting periods. These statements are designed to disclose (i) Absolute figures, (ii) Changes in absolute figures, (iii) Absolute data in terms of percentages and (iv) Changes in terms of percentages. Comparative figures will indicate the trend and direction of financial position and operating results. The two comparative statements are Balance Sheet and Income statement of an or�ganisation.
COMPARATIVE BALANCE SHEET :
It represents not merely the balance of accounts drawn on two different dates but also the extent of their increase or decrease between these two dates. It focuses on the changes that have taken place in one accounting period. The changes are the direct outcome of operational activities. To understand the comparative balance sheet, it must have two columns for the data of original balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.By comparing the balance sheets of different dates, one can observe the following aspects:-
Current financial position and Liquidity position
Long-term financial position
Profitability of the concern
Ratio analysis
The most common method of financial analysis involves the calculation of ratios from the income statement and balance sheet. Financial ratios are used to analyze a company's liquidity, profitability, financial leverage and asset turnover.
Ratios are calculated for a series of reporting periods to identify positive or negative trends over time. A company's ratios can be also be compared to the benchmark ratios reported by other firms in the same industry. The comparison of a company's ratios to industry statistics gives an indication of whether the business is underperforming or overperforming relative to its competitors.
Trend Analysis
Also known as the Pyramid Method. Studying the operational results and financial position over a series of years is trend analysis. Calculations of ratios of different items for various periods is done & then compared under this analysis. Whether the enterprise is trending upward or backward, the analysis of the ratios over a period of years is done. By observing this analysis, the sign of good or poor management is detected.
Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on the graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
Common Size Statements
A vertical presentation of financial information is followed for preparing common-size statements. Besides, the rupee value of financial statement contents are not taken into consideration. But, only percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items are compared to the total assets, total liabilities or sales in terms of percentage. Thus, a common size statement shows the relation of each component to the whole. Separate common size statement is prepared for profit and loss account as Common Size Income Statement and for balance sheet as Common Size Balance Sheet.
Statement of Changes in Working Capital
The objective of this analysis is to extract the information relating to working capital. The amount of net working capital is determined by deducting the total of current liabilities from the total of current assets. The statement of changes in working capital provides the information in relation to working capital between two financial periods.
Fund Flow Analysis
Fund may be interpreted in various ways as (a) Cash, (b) Total current assets, (c) Net working capital, (d) Net current assets. For the purpose of fund flow statement the term means net working capital. The flow of fund will occur in a business, when a transaction results in a change i.e., increase or decrease in the amount of fund.According to Robert Anthony the funds flow statement describes the sources from which additional funds were derived and the uses to which these funds were put.In short, it is a technical device designed to highlight the changes in the financial condition of a business enterprise between two balance sheets.
cost volume profit (CVP) analysis
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. CVP analysis estimates how much changes in a company's costs, both fixed and variable, sales volume, and price, affect a company's profit. This is a very powerful tool in managerial finance and accounting. It is one of the most widely used tools in managerial accounting to help managers make better decisions.
Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on the graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
CONCLUSION
In General Financial statements are the report card of business. Whether you are a new investor, a small business owner, an executive, or just trying to keep track of your personal finances, you need to understand how to read, analyze, and create financial statements so you can get a full and accurate understanding of your finances. Financial statements will tell you how much money there is, how much debt is owed, the income coming in each month, and the expenses going out the door.
REFERENCES
Thomas R. Ittelson (1998) , Financial Statements: A Step-by-step Guide to Understanding and Creating Financial Reports, Cornell University, Career Press.
M. Fridson, F. Alvarez (1991) , Financial statement analysis: a practitioner's guide, the University of California, Wiley.
E. Helfert (1963), Techniques of Financial Analysis, Jaico Publishing House
Will, I., Subramanyam, K. R., & Robert, F. H. (2001). Financial statement analysis. McGraw-Hill Internation.
Stickney, C. P. (1993). Financial statement analysis. Dryden.
Financial statements are written records that convey the financial activities and conditions of a business or entity and consist of four major components. Financial statements are meant to present the financial information of the entity in question as clearly and concisely as possible for both the entity and for readers. Financial statements for businesses usually include income statements, balance sheets, statements of retained earnings and cash flows but may also require additional detailed disclosures depending on the relevant accounting framework. Financial statements are often audited by government agencies, accountants, firms to ensure accuracy and for tax, financing or investing purposes.
Importance Of Financial Statements.
The importance of financial statements lies in their utility to satisfy the varied interest of different categories of parties such as management, creditors, public. The utility of financial statements to different parties are discussed in detail as follows:
Investors:
The investors include both short-term and long-term investors. They are interested in the security of the principal amount of loan and regular interest payments by the concern. The investors will study the long-term solvency of the concern with the help of financial statements. The investors will not only analyze the present financial position but will also study future prospects and expansion plans of the concern. The possibility of paying back the loan amount in the face of liquidation of the concern is also taken into consideration.
Labour
Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations also, the size of profits and profitability achieved are greatly relevant.
Stock Exchange:
The stock exchanges deal in purchase and sale of securities of different companies. The financial statements enable the stock brokers to judge the financial position of different concerns. The fixation of prices for securities, etc., is also based on these statements.
Government:
The financial statements are used to assess tax liability of business enterprises. The government studies economic situation of the country from these statements. These statements enable the government to find out whether business is following various rules and regulations or not. These statements also become a base for framing and amending various laws for the regulation of business.
Management:
The financial statements are useful for assessing the efficiency for different cost centres. The management is able to exercise cost control through these statements. The efficient and inefficient spots are brought to the notice of the management. The management is able to decide the course of action to be adopted in future.
Creditors:
The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. The calculation of current ratio and liquid ratio will enable the creditors to assess the current financial position of the concern in relation to their debts.
Bankers:
The banker is interested to see that the loan amount is secure and the customer is also able to pay the interest regularly. The banker will analyze the balance sheet to determine financial strength of the concern and profit and loss account will also be studied to find out the earning position.
A banker has a large number of customers and it is not possible to supervise their business activities. It is through the financial statements that a banker can keep a watch on the business plans and performances of its customers. These statements also help the banker to determine the amount of securities it will ask from the customers as a cover for the loans.
Trade Associations:
These associations provide service and protection to the members. They may analyze the financial statements for the purpose of providing facilities to these members. They may develop standard ratios and design uniform system of accounts.
Shareholders
Management is separated from ownership in the case of companies. Shareholders cannot, directly, take part in the day-to-day activities of business. However, the results of these activities should be reported to shareholders at the annual general body meeting in the form of financial statements.
These statements enable the shareholders to know about the efficiency and effectiveness of the management and also the earning capacity and financial strength of the company.
Limitations of Financial Statements
The limitations of financial statements are those factors that a user should be aware of before relying on them to an excessive extent. Knowledge of these factors could result in a reduction of invested funds in a business, or actions taken to investigate further. The following are all limitations of financial statements:-
(i) Manipulation or Window Dressing
Some business enterprises resort to manipulate the information contained in the financial statements so as to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing.
(ii) Use of Diverse Procedures
There may be more than one way of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between such enterprises. For example, depreciation can be charged under straight line method or written down value method. However, results provided by comparing the financial statements of such business enterprises would be misleading.
(iii) Qualitative Aspect Ignored
The financial statements incorporate the information which can be expressed in monetary terms. Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For example, a conflict between the marketing manager and sales manager cannot be recorded in the books of accounts due to its non-monetary nature, but it will certainly affect the functioning of the activities adversely and consequently, the profits may suffer.
(iv) Dependence on historical costs.
Financial statements are historical in nature as they record past events and facts. Due to continuous changes in the demand of the product, policies of the firm or government etc, analysis based on past information does not serve any useful purpose and gives only postmortem report.
(v) Price Level Changes
Figures contained in financial statements do not show the effects of changes in the price level, that is price index in one year may differ from price index in other years. As a result, misleading picture may be obtained by making a comparison of figures of past year with current year figures.
(Vi)Not verified.
If the financial statements have not been audited, this means that no one has examined the accounting policies, practices, and controls of the issuer to ensure that it has created accurate financial statements. An audit opinion that accompanies the financial statements is evidence of such a review.
(vii) Subjectivity and Personal Bias
Conclusions drawn from the analysis of figures given in financial statements depend upon the personal ability and knowledge of an analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net profit before tax, while another analyst may take it as net profit after tax.
(viii) Lack of Regular Data/Information:
Analysis of financial statements of a single year has limited uses. The analysis assumes importance only when compared with financial statements, relating to different years or different firm.
(ix) No predictive value.
The information in a set of financial statements provides information about either historical results or the financial status of a business as of a specific date. The statements do not necessarily provide any value in predicting what will happen in the future. For example, a business could report excellent results in one month, and no sales at all in the next month, because a contract on which it was relying has ended.
(X) Not always comparable across companies.
If a user wants to compare the results of different companies, their financial statements are not always comparable, because the entities use different accounting practices. These issues can be located by examining the disclosures that accompany the financial statements.
FINANCIAL STATEMENT TOOLS
There are various tools are used to study the relationship between different statements. An effort is made to use those tools or techniques which clearly analyse the financial position of the enterprise. The following are tools of financial statements:-
COMPARATIVE FINANCIAL STATEMENTS :
The comparative financial statements will provide a compari�son between two stipulated periods for an organisation. It will also provide a comparison for two or more enterprises for one or more accounting periods. These statements are designed to disclose (i) Absolute figures, (ii) Changes in absolute figures, (iii) Absolute data in terms of percentages and (iv) Changes in terms of percentages. Comparative figures will indicate the trend and direction of financial position and operating results. The two comparative statements are Balance Sheet and Income statement of an or�ganisation.
COMPARATIVE BALANCE SHEET :
It represents not merely the balance of accounts drawn on two different dates but also the extent of their increase or decrease between these two dates. It focuses on the changes that have taken place in one accounting period. The changes are the direct outcome of operational activities. To understand the comparative balance sheet, it must have two columns for the data of original balance sheets. A third column is used to show increases/decrease in figures. The fourth column gives percentages of increases or decreases.By comparing the balance sheets of different dates, one can observe the following aspects:-
Current financial position and Liquidity position
Long-term financial position
Profitability of the concern
Ratio analysis
The most common method of financial analysis involves the calculation of ratios from the income statement and balance sheet. Financial ratios are used to analyze a company's liquidity, profitability, financial leverage and asset turnover.
Ratios are calculated for a series of reporting periods to identify positive or negative trends over time. A company's ratios can be also be compared to the benchmark ratios reported by other firms in the same industry. The comparison of a company's ratios to industry statistics gives an indication of whether the business is underperforming or overperforming relative to its competitors.
Trend Analysis
Also known as the Pyramid Method. Studying the operational results and financial position over a series of years is trend analysis. Calculations of ratios of different items for various periods is done & then compared under this analysis. Whether the enterprise is trending upward or backward, the analysis of the ratios over a period of years is done. By observing this analysis, the sign of good or poor management is detected.
Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on the graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
Common Size Statements
A vertical presentation of financial information is followed for preparing common-size statements. Besides, the rupee value of financial statement contents are not taken into consideration. But, only percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items are compared to the total assets, total liabilities or sales in terms of percentage. Thus, a common size statement shows the relation of each component to the whole. Separate common size statement is prepared for profit and loss account as Common Size Income Statement and for balance sheet as Common Size Balance Sheet.
Statement of Changes in Working Capital
The objective of this analysis is to extract the information relating to working capital. The amount of net working capital is determined by deducting the total of current liabilities from the total of current assets. The statement of changes in working capital provides the information in relation to working capital between two financial periods.
Fund Flow Analysis
Fund may be interpreted in various ways as (a) Cash, (b) Total current assets, (c) Net working capital, (d) Net current assets. For the purpose of fund flow statement the term means net working capital. The flow of fund will occur in a business, when a transaction results in a change i.e., increase or decrease in the amount of fund.According to Robert Anthony the funds flow statement describes the sources from which additional funds were derived and the uses to which these funds were put.In short, it is a technical device designed to highlight the changes in the financial condition of a business enterprise between two balance sheets.
cost volume profit (CVP) analysis
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. CVP analysis estimates how much changes in a company's costs, both fixed and variable, sales volume, and price, affect a company's profit. This is a very powerful tool in managerial finance and accounting. It is one of the most widely used tools in managerial accounting to help managers make better decisions.
Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on the graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
CONCLUSION
In General Financial statements are the report card of business. Whether you are a new investor, a small business owner, an executive, or just trying to keep track of your personal finances, you need to understand how to read, analyze, and create financial statements so you can get a full and accurate understanding of your finances. Financial statements will tell you how much money there is, how much debt is owed, the income coming in each month, and the expenses going out the door.
REFERENCES
Thomas R. Ittelson (1998) , Financial Statements: A Step-by-step Guide to Understanding and Creating Financial Reports, Cornell University, Career Press.
M. Fridson, F. Alvarez (1991) , Financial statement analysis: a practitioner's guide, the University of California, Wiley.
E. Helfert (1963), Techniques of Financial Analysis, Jaico Publishing House
Will, I., Subramanyam, K. R., & Robert, F. H. (2001). Financial statement analysis. McGraw-Hill Internation.
Stickney, C. P. (1993). Financial statement analysis. Dryden.
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