Financial statements and financial ratios are crucial for communicating financial information to stakeholders, including banks, investors, and suppliers. These documents are essential for evaluating a business’s performance and gaining insights into different aspects of the company. Financial information and ratios serve as vital tools for predicting company growth and comparing it with industry peers. Stakeholders can be either internal (employees, managers, board members) or external (investors, customers, suppliers). It is important for stakeholders to understand the company’s performance. Financial reporting provides information that helps assess the credibility of the company, enabling investors and creditors to determine the wise utilization of their investments and potential returns they can expect. Employees also rely on financial information for future planning.
The fifth company is experiencing financial challenges that could lead to no salary raises or potential bankruptcy, jeopardizing job security for employees. Several internal stakeholders hold stock options in the company, making it essential for them to evaluate its financial stability as it directly affects their earnings. Both internal and external stakeholders have a vested interest in comprehending how their investments are being handled, emphasizing the significance of conducting a thorough examination of the company’s financial statements.
Financial statements play a crucial role for stakeholders as they offer essential information about a company’s profitability, comparison of assets and liabilities, sources of capital, utilization of investments, reinvestment of profits, and potential for future growth. Various financial reports such as the balance sheet, income statement, and cash flow statement provide significant financial insights. Specifically, the balance sheet reveals a company’s present financial status.
According to Hung & Ghana (2012), the balance sheet is a vital component of a financial report that illustrates the company’s performance on a particular date. It offers essential information for investors to assess the company’s worth by showcasing how its financial resources are acquired and distributed for operations. The balance sheet displays assets, liabilities, and shareholders’ equity, with assets such as cash, fixed assets, and intangibles (trademarks, patents, goodwill, etc.) listed on the left side or top of the balance sheet.
Liabilities and shareholders’ equity are positioned on the right side or below assets in the balance sheet. Current liabilities take precedence over long term debt, with top priority liabilities listed first. Shareholders’ equity is placed last as it relies on any remaining funds. The balance sheet highlights the disparity between assets and liabilities, referred to as shareholders’ equity or net worth, documenting the agreed upon dollar value in transactions.
Stakeholders can analyze the balance sheet to examine major asset categories, while the income statement focuses on events occurring within a specific time period. The balance sheet enables stakeholders to compare assets and liabilities for various analyses, while the income statement provides an overview of company performance and summarizes profit-generating activities during a defined time period.
The income statement is a financial document that displays a company’s profitability. It commences with net sales and encompasses the cost of goods sold (COGS), which covers expenses associated with manufacturing the product like labor, freight, and royalties. Notably, COGS does not incorporate the labor involved in selling the product. Gross profit is determined by subtracting COGS from net sales, representing the amount prior to deducting operating expenses and taxes. Subsequently, the income statement enumerates operating expenses.
The operating income is determined by subtracting various expenses, such as rent, utilities, office supplies, and other operating costs, from the gross profit. Other income sources not related to the main business, like interest income, are categorized as other income and separately listed. The arrangement of items on the income statement is typically based on their relevance and ability to predict future earnings (Bartok & Moran, 2014). Higher-ranked items hold greater importance in terms of valuation. While a company’s income statement may indicate profitability, sufficient cash flow is necessary to fulfill debt obligations for sustained success. To prevent cash flow problems and forecast financials accurately, companies should regularly prepare a cash flows statement. The income statement helps stakeholders identify weaknesses in previous year’s financials and predicts future performance. Furthermore, the cash flow statement acts as a valuable tool for forecasting a company’s future financial situation.
According to Spindled, Seep, & Nelson (2011), the cash flows statement can assist companies in making financial decisions regarding when funding will be needed to pay bills or expand the business. It can also provide valuable information for assessing future profitability, liquidity, and long-term solvency. The cash flows statement only reflects cash activities, including when cash is paid out and received. By analyzing this statement, companies can determine when they need additional funding and whether borrowing should be considered.
The cash flow statement categorizes a company’s cash flows into three activities for a specific accounting period: operating, investing, and financing. Operating activities cover cash flows associated with daily operations, including accounts receivables, accounts payable, and other operational expenses like advertising, administrative costs, interest, and tax payments. Investing activities encompass cash flows used for acquiring property and equipment to support the company’s growth.
The cash generated from selling assets is considered as cash inflow from investing activities, while financing activities encompass cash flows from lenders, debt holders, and owners of the company. The statement of cash flows demonstrates how operating, investing, and financing activities are interconnected. It indicates whether the company is generating enough cash to meet current and future needs, making it a vital source of information. The cash flow statement offers stakeholders valuable insights into fund repayment and the funding required for operational expenses.
Management needs to exercise caution when dealing with company debt. Modifications to balance sheet accounts can offer insight into year-end actions and potential payment solutions. However, it becomes difficult to track short-term loan repayments separately. Additionally, this approach does not indicate if profit resulted from an increase in volume or price, a decrease in cost of goods sold, or reduced expenses. Employing ratio and expense analyses can assist in determining such factors.
Ratio analysis is a method of comparing financial figures to assess a company’s performance and risk (Spindled, Seep, & Nelson, 2011). It is beneficial for investors, creditors, and stakeholders as it provides insights into the company’s creditworthiness and stability. Additionally, ratios help companies evaluate progress and identify areas for improvement.
The key ratios used for financial statement analysis include liquidity analysis, profitability analysis, activity analysis, capital structure analysis, capital market analysis, and ROAR (profit margin x asset turnover).
According to Eager, Aster, & Demean (2012), liquidity and solvency ratios play a crucial role in determining an entity’s financial position. Conversely, the economy, profitability, and investment ratios provide insights into business efficiency. Liquidity ratios aid in evaluating a company’s ability to fulfill its current debt obligations. The fundamental liquidity ratios encompass the current ratio, acid-test Asia, debt to equity ratio, and times interest earned ratio. Liquidity ratio represents the availability of assets that can be readily converted into cash.
This information is crucial for determining how to promptly pay off debt and whether creditors are demanding repayment. It can also provide insight into a company’s potential bankruptcy. The two primary ratios used in financing are the debt to equity ratio and the time interest earned ratio. The debt to equity ratio compares the money contributed by creditors with the owner’s equity in the business. The time interest earned ratio assesses the company’s ability to meet fixed debt obligations by comparing interest charges with available income (Spindled, Seep, & Nelson, 2011).
The time interest earned ratio is a useful tool for creditors to determine the company’s investment safety. Profitability ratios, such as return on sales, return on assets, and return on investment, allow stakeholders to evaluate the company’s performance. Most business individuals prioritize generating profits. Profitability is calculated by dividing net income by sales, resulting in a profit margin. A higher profit margin indicates better company performance. The profit ratio can be influenced by changes in price and/or volume. Modifying the price can easily impact ratios by either increasing or decreasing them.
Political and economic issues can impact a company’s profitability trend over time. The activity ratio is a crucial indicator of a company’s ability to convert its accounts within the balance sheet into cash through sales. This ratio is significant as it determines how well a company is generating income from its resources. It measures the effectiveness of a company in utilizing its assets, leverage, and other items on the balance sheet. The faster a company can transform production into sales, the more rapidly it can generate higher revenue.
The analysis of different companies often involves the use of activity ratios. There are two primary types of these ratios: asset turnover ratio and inventory turnover ratio. By referring to the balance sheet, stakeholders can determine the assets-to-debt ratio by dividing total assets by liabilities. This calculation helps assess the level of leverage and whether a company has exceeded its limits. Additionally, examining the proportion of current assets enables stakeholders to evaluate a company’s liquidity and ability to manage unexpected debt.
The asset turnover ratio is utilized to evaluate if a company effectively utilizes its assets to generate more sales per dollar of assets. This calculation involves dividing the sales by average total assets. A high ratio indicates efficient asset utilization.
Private companies, such as ours, frequently need funding for operational expenses. For instance, the company I work for is privately held and presently seeking to become a publicly traded entity. To accomplish this goal, we must reach a certain revenue level that requires investment from investors.
Before making significant investments, it is necessary for potential investors to assess a company’s stability and profitability. Accurate financial statements provide the necessary data for investors to analyze ratios and evaluate the company’s performance. Financial statements are relied upon by both internal and external stakeholders alike, as they help determine the company’s strength and its viability as an investment opportunity. Understanding whether or not a company is profitable is crucial for all stakeholders involved. The key to success lies in analyzing financial information and making predictions about future outcomes.
