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Companies prepare financial statements and reports to show the financial affairs and status of the entity. Debarshi (2011, p.12) defines financial statements as a systematic documentation of financial information prepared by an accountant using internationally accepted accounting conventions and standards to reveal the performance of a business. These reports are prepared using accounting standards and concepts formulated by the International Accounting Standards Board (IASB), formerly known as the International Accounting Standards Committee (IASC). The board established an accounting framework that defined the principles to be followed in the preparation of financial statements. This enhanced consistent in the production and presentation of financial information.

 

However, IASB (2009, p.76) observes that though there are consistencies in the preparation and presentation of financial statements from country to country, different countries have set their own national financial reporting requirements, which have been influenced by social, legal and economic environment of a country. International Accounting Standards Board is of the contrary opinion since they believe that harmonised procedures, rules and standards in the preparation and presentation of financial statements in all countries will serve well interests of financial statement users. The board affirms that most of the users of financial statements are interested in making economic decisions, making it possible to harmonise the preparation and presentation of financial information.  Thukaram (2007, p.43) posit that majorly financial statements are used in making economic decisions for the purpose of investments, taxation, entity control, collective bargaining agreements and loans.

Financial Statements

Nikolai, Bazley and Jones (2009, p.61) state that according to the IASB, objectives of financial statements include: presenting information on the financial position of an entity; revealing financial performance of an entity and reflecting changes in the equity structure of an entity. These objectives are captured and reflected in four types of financial statements, which include statement of financial position, comprehensive income statement, cashflow statement and statement of changes in equity. Preparation of these statements is at the end of an accounting period; though, in some countries, the time of preparation and presentation is guided by statutory requirements. For example, listed entities on the London Stock Exchange are required by law to publish their financial statements on an annual and semi-annual basis (London Stock Exchange, 2010, p.42).

The statement of financial position or balance sheet provides information on an entity’s assets and liabilities as on a particular date, usually the end of an accounting period. It therefore shows the financial position of an entity. The statement of comprehensive income or profit and loss account is prepared to illustrate trading results from operations of an entity in a particular accounting or financial period. It therefore provides information on an entity’s cost of production, operational and non operational income, operational and non-operational expenses. This information culminates with determination of profit or loss for that accounting or trading period. Cash flow statement is prepared to present cash flow information of an entity. The statement provides information on cash inflows and cash outflows of an entity. According to Rao (2010, p. 272) cash flow reveals the amount of cash generated or used in the operations of an entity. Lastly, statement of changes in equity provides information on the changes in composition of equity in a particular accounting period. Nikolai, Bazley and Jones (2009, p.59) observes that the statement of changes in equity provides information on material changes of share capital, retained earnings, revaluation surplus, share premium and unrealised gains and losses on investments.

 

These financial statements are prepared using accounting models. The models are based on two concepts, which include historical costs concept and capital maintenance concept (Patra, 2006, p.11). Nikolai, Bazley and Jones (2009, p.38) point out that the IASB proposes two assumptions that underlie the preparation of financial reports and statements, which include the accrual basis and going concern basis. Accrual basis of accounting assumes that transactions should be recorded in accounting books and financial statements when they materialise or occur and not when cash or equivalent change hand between the involved parties. Going concern assumption, on the other hand, posits that the reporting entity will be in business in the foreseeable future, and therefore has no plans to scale down its operational activities or liquidate its assets (Nikolai, Bazley and Jones, 2009, p.38). IASB recommends that financial information contained in financial statements should uphold four key qualities. These characteristics are relevance, understability, comparability and reliability (Nikolai, Bazley and Jones, 2009, p.61). Relevance means that financial information in financial statements should be applicable to users in making economic decisions. Therefore, relevance of financial information is encapsulated in its materiality. Consequently, mis-statement or omission of it leads to disproportionate economic decisions. Understability means that financial statements should contain information that is readily explicable by the relevant users who have business knowledge. Comparability means that users should be able to compare financial information of an entity over time and with those of different entities. Lastly, financial information contained in financial statements should be free from biasness and can truthfully be taken by relevant users as a true representation of the entity’s performance, which is what IASB describes as reliability.

Categories of Financial Statement Users

Financial statements are used by different users who have business and economics knowledge to deduce material information that is applicable in making sound economic decisions. According to Melicha, Norton and Town (2006), the ability of users to effectively analyse financial statements of an entity determines success of the user in the business environment. Users of financial statements heavily rely on analytical methods, mainly mathematical, statistical, financial and economics methods, to draw analyse and make economic decisions on the entity’s business performance. Nikolai, Bazley and Jones (2009, p.7) classify users of financial statement into two categories; namely, internal and external users. Internal users are persons who have direct connection or control on the entity’s operations. They include managers, employees and owners of a business entity, whereas external users include potential and institutional investors, lenders, creditors, suppliers, government agencies, customers and public.

Management and employees

Managers and owners are responsible for the running of the business entity and therefore require high quality information processing mechanisms to enable them make sound economic and managerial decisions. Financial statements form the basis of this information processing mechanism. According to Melicha, Norton and Town (2006) financial statements play a critical role in management decision making process.  The information contained in financial statements is analysed to help the management effectively utilize the resource of the company and achieve the entity’s objective. For example, the management uses the statement of financial position to deduce the financial position of the entity at a particular date. Through carefully analysing assets and liabilities of the entity, managers and owners can be able to deduce weaknesses of a business entity and take remedial actions. A statement of comprehensive income helps the management and owners of a business entity analyse the entity’s income and expenses. Therefore, they are able to deduce whether the company is operating at a profit or loss. This is critical for predicting the survival of a company. Any weaknesses, may be expenses exceeding income, triggers the management to take necessary actions to foster performance and growth. Management and owners of a company are not only interested with the entity’s financial statement but also of competitors. Comprehensive analysis of a competitors financial statement help the management of the entity understand the strength and weaknesses of the competitor. This can therefore be used as a tool to gain competitive advantage. Employees, on the other hand, use financial statements as a tool of negotiation for collective bargain agreement, which includes promotions, salary hikes, promotions and ranking. Additionally, employees are interested in financial stability of a company to determine the ability of their employers to meet their retirement benefits obligations, working condition, job security and other future employment opportunities. This is because a business entity with good business performance is likely to expand and offer better pay whereas an entity facing dwindling fortunes is likely in the near future to downsize its workforce.

Investors

In a limited liability company, ownership and management are separated. Therefore, owners, in this case investors, assess the performance of a business entity to determine the performance of their investments. This assessment help them make decisions of whether to buy, sell or hold their stake in the entity; evaluate performance of the management; establish utilization efficiency of the entity’s resources and forecast cash generation ability of the business in the future. According to Melicha, Norton and Town (2006), investing in a company is a risky investment and therefore investors should have beforehand relevant information to enable them make sound economic decisions. Financial statements help investors assess risks inherent in the venture and returns they expect to establish the viability of the entity. In the case of listed companies, individual investors and institutional investors heavily rely on financial statements to make their buy, sell or hold decision. This is achieved by comparing the performance of an entity with other similar entities in a given period or comparing the performance of entity in a given time period with other periods. Additionally, financial statements contain management and auditors opinion which elaborate management’s outlook on the future prospects of the business. This information is material in helping investors assess, analyse and project the financial and economic stability of the entity.

Lenders

Business entities obtain funds from venture capitalists, business angels or financial institutions, which is in the form of loans or venture capital. The funds advanced to an entity are either on short or long term basis; therefore, the loan creditor must first assess the economic and financial stability of the borrower to determine viability and duration of loan repayment. Loan creditors use financial statements to calculate the probability or risk of default by the borrower. Financial institutions require cash flow statements to evaluate cash flow projections of an entity to determine how the entity intends to meet repayment obligations (Melicha, Norton and Town, 2006). A statement of financial position and statement of comprehensive income is also required to determine the cost of capital that the lender requires from the entity. A highly leveraged entity is at high risk of default, requiring high cost of capital from the borrower. An illiquid entity has high probability of failing to meet its repayment obligation, attracting high cost of capital. Venture capitalists, on the other hand, analyse financial statements to determine the amount of funds to advance to an entity in exchange of an equity stake in the entity.  This is done by analysing, evaluating and projecting business performance of an entity to determine the value of the entity now and in the future.

Suppliers and trade creditors

Just like loan creditors, suppliers and trade creditors, are interested with information to assess the credit worthiness of an entity. Most suppliers and trade creditors prefer entities that are able to pay their account payables over a short period of time since there supplies are unsecured (Melicha, Norton and Town, 2006). In case the entity winds up, they are among the last parties to be paid out of the entities assets. Therefore, suppliers and creditors carefully analyse financial statements of an entity to ascertain their ability to settle their account payables. This information can readily be available from credit rating agencies, which use financial statements to obtain a credit score for a business entity.

Financial Ratio Analysis

Investors ratios

Investors are concerned with the return that they obtain from their investment. Majorly the following are investor ratios; namely, earning per share, price to earning ratio, dividend cover, dividend yield and dividend per share.

 

Lenders and loan creditors use the following ratios to determine solvency, financial risk and liquidity ability to pay borrowed funds.

Gearing ratio: it is a ratio used by banks to measure financial risk of borrowers.

 

Debt to equity ratio: it is a ratio that measures the amount of capital shareholders have invested in an entity for every pound borrowed.

 

Interest cover: it is a ratio that measures the number of times interest payable can be able to be covered by profit generated.

 

Debt service or coverage ratio: it is a ratio that measures an entity’s ability to pay its debts from profit generated.

 

Our financial analysis essay writing service assists students prepare professional ratio analysis for any listed public company. In this ratio analysis assignment pdf, we analyze financial ratios for Cranswick. Cranswick Plc is a food supplier company listed on the London Stock Exchange. The following represent ratios for the company for the year ended 31st March 2012.

Financial Statement Analysis Example

REFERENCES

Cranswick PLC (2012) Report & accounts, viewed 20th August 2012 http://www.cranswick.plc.uk/downloads/Cranswick_R_A_2012.pdf

 

Debarshi, B 2011, Management accounting, Pearson Education India, New Delhi

 

International Accounting Standards Board 2009, International financial reporting standards, Kluwer, London.

 

London Stock Exchange 2010, A guide to listing on the London Stock Exchange, viewed on 20th August, 2012, http://www.londonstockexchange.com/home/guide-to-listing.pdf

 

Melicher, RW, Norton, E & Laura, T 2006, Finance, John Wiley & Sons, Indiana

 

Nikolai, LA, Bazley, JD & Jones, JP 2009, Intermediate accounting, Cengage Learning, Ohio

 

Patra, K 2006, Accounting and finance for managers, Sarup & Sons, New Delhi.

 

Rao, RM 2011, Financial statement analysis and reporting, PHI learning Private Limited, New Delhi

 

Thukram, RE 2007, Management accounting, New Age International, New Delhi.

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