What is Financial Statement?
Financial statement analysis (or financial analysis) is the process of reviewing and analysing a company's financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.
Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders' equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders' equity report information for a period of time (or time interval) such as a year, quarter, or month. In other words, financial statement shows the profit and loss for a particular period and the position of company at a point of time.
Globally, publicly listed companies are required by law to file their financial statements with the relevant authorities. For example, publicly listed firms in America are required to submit their financial statements to the Securities and Exchange Commission (SEC). Firms are also obligated to provide their financial statements in the annual report that they share with their stakeholders. As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted.
Users of Financial Statement Analysis
Management- Managers of the company need to make certain decisions regarding to company. These decisions are very much affected by the profit or loss of the organization. So, to know the profit of the company, management prepares financial statements of the organization.
Owners- Small business organization owners' need to know whether their business is profitable or not. Because sometime it may happen that their company is facing loss situation for a period of more than 2-3 years and if they don't prepare financial statements, they won't be knowing the answers to the questions regarding continuity of business.
Investors- People who have purchased stock or shares in a company need financial information to analyse the way the company is performing. They use financial statement analysis to determine what to do with their investments in the company. So, depending on how the company is doing, they will either hold onto their stock, sell it or buy more.
Creditors- They are one of the major element in company's business. Creditors are those who lend money to company and to get money from them, company need to tell them the credibility of the company. Creditors look in to the statement of cash flows to measure its liquidity and to meet its short-term payments.
Government- Government are interested in financial statements to determine how the economy is performing in general so they can plan their financial and industrial policies. Tax authorities also look into the statements to calculate the tax burden of the company.
Customers- Customers need to know about the ability of the company to service its clients into the future. The need to know about the company’s stability of operations is heightened if the customer (i.e. a distributor or procurer of specialized products) is dependent wholly on the company for its supplies.
General Public- Students, Analysts and Researchers might need financial data to evaluate the effect of the firm in the environment or the economy or even the local community. For example, if the company is following Corporate Social Responsibility Policies, customer may look into the future prospects of the company.
Types of Financial Statements
Balance Sheet- The balance sheet, which is also known as the statement of financial position, reports a corporation's assets, liabilities, and stockholders' equity account balances as of a point in time. The point in time is often the final instant or moment of the accounting period.
Income Statements- The income statement reports a corporation's net income for the period of time indicated in its heading. The income statement is also known as the statement of income, statement of earnings, statement of operations, profit and loss statement, or P&L.
Statements of Equity Changes- The financial statement that lists the components of stockholders' equity, their balances, and the changes that occurred during an accounting year is also known by the following titles:
- Statement of Stockholders' Equity
- Statement of Shareholders' Equity
- Statement of Changes in Stockholders' Equity
- Statement of Changes in Shareholders' Equity
Statements of Cash flows- The statement of cash flows (SCF) or cash flow statement reports a corporation's significant cash inflows and outflows that occurred during an accounting period. This financial statement is needed because many investors and financial analysts believe that "cash is king" and use cash amounts for various analyses. The SCF is also important because the income statement is prepared using the accrual method of accounting (as opposed to the cash method).
What is the purpose/objectives of financial statement?
1) Business owners and managers requires financial statement to make different decision regarding different policies of the company. They are also used as a supporting evidence of company's work in an accounting year.
2) It affects the investor's decision regarding investment in the company. They help the investors in knowing the position of the company so that they get the idea about the return.
3) Business requires money for their operation and for this, they approach various banks and other financial institutions. Banks assess the financial report of the company and make decision whether to grant loans or not.
4) Comparison- Companies can know the growth of their organization in an year by comparing current year's financial data with the past year data. For example- if company wants to the increase in sales in year 2016-17, then they will compare the Revenue from Operations of 2016-17 with 2015-16 and if it exceeds then it is a good sign for the company and if it is lower than the last year then it means there is a deviation which is needed to be rectify.
5) To avail various benefits- There are certain benefits, incentives provided by the government and to avail those benefits, company prepares financial data. For example-
Importance of Financial Statement
1) Financial Condition- Financial condition of the company is the major concern for the investors and creditors. As a creditor, they rely on financial statement for the safety and profitability of their investment.
2) Operating Result- Since Balance Sheet provides only the overview of assets, liabilities and equity of the company, investors also look for the result from the operation of the company. Statement of profit and loss provides the sale from the operation and other expenses which are incurred in the process.
3) Shareholders' Equity- The statement of equity is especially important for the shareholders' because it show the changes in the equity and also the retained earnings. Statement of equity also shows the earning per share, which is a major factor in investor's decision making process.
4) Government policies- Various government policies require data from the industries. These data comprise of company's policies, statement of affairs, balance sheet and annual report.
5) Taxation- For the purpose of taxation, authorities require to know the income of the company in the assessment year and this information are provided in the company's financial statement. And to avail various benefits and incentives provided by the government, they need to provide evidence.
6) Importance to Labour- The financial statement provides the profit and loss account of the business. This enables the staff to identify the profit condition of the business and helps to negotiate for the better salary because the profit of the company depends on the salary for the staffs.
Limitations of the Financial Statements
- Comparability between companies- Generally the comparison between the companies happen on the basis of the ratios but ratios are not the correct measure to compare. Reason being, ratios can be manipulated by the management of the company or company follows different way to measure ratio. So there is not one method that is followed by any company, hence the comparison cannot be done.
- Comparability between periods- The change in accounts where financial information is stored may skew the results of the financial statement analysis, from one period to the next. For example, if a company records an expense in one period as cost of goods sold, while in another period, it is recorded as a selling and distribution expense, the analysis between those two periods would not be comparable.
- Based on specific time period- A user of financial statements can gain an incorrect view of the financial results or cash flows of a business by only looking at one reporting period.
- Biasedness- Management of the company may skew the results. It may happen when there is a pressure from the head to report excellent results.
- Not verified- Until and unless accounting statements are not audited, it is not trustworthy. Because it means that no one has examined the policies, practices and the control. An audit opinion that accompanies the financial statements is evidence of such a review.
Standard of Comparison for financial statements
- Rule of Thumb
- Industry Standards
- Past data
Sources of the Data in financial statement
- Company's report.
- Stock Exchanges.
- Business Periodicals.
- Information Services. (CRISIL, ICRA, CMIE)
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