Financial statements are important in providing an overview of the company’s financial condition both in short and long term. Financial statements should be understandable, relevant, reliable, and comparable and are used by owners, managers, investors to help them make important business decisions. The audience, purpose, and nature of financial statements and managerial reports will be examined. In addition, the use of financial accounting information in making informed and ethical business decisions will be discussed.
What are financial statements? Financial statements are part of a process of financial reporting which provide information about the financial strength,
performance, and changes in financial position of a company that is useful in making economic decisions. Financial statements include an income statement, a balance sheet and a cash flow statement and owners and managers require financial statements to assist them in making business decisions that affect the performance of the company (Block & Hirt, 2005). Management of the company is primarily responsible for preparing and presenting financial statements of the firm and all reports included the date prepared, the period covered, and descriptive labels and titles are comprehensible to the general reader. The reports are produced annually and often generated quarterly or monthly and frequent reports are more useful as management tools because they are based on current data and provide more opportunities to react to changes in financial markets.
Financial statements are also used by employees and their representatives to determine company’s ability to provide retirement benefits and employment opportunities, and the company’s stability and profitability. Moreover, government and their agencies rely on financial statements to regulate the company’s activities, determine taxation policies, and as the basis of national income and similar statistics.
Financial statements contain important information for investors, providers of risk capital to the company and their advisers are concerned with the risk inherent in, and return provided by their investments. Investors rely on financial statements to assess management’s accountability and determine whether to hold or sell their investment, reappoint or replace management. Shareholders are interested in information to assess the ability of the company to pay dividends.
“An income statement is a major device for measuring the profitability of a firm over a period of time” (Block & Hirt, 2005, p. 3) and also shows the costs and expenses associated with generated revenues and net earnings or losses. Income statements also report earnings per share or a calculation that shows how much money shareholders would receive if the company decided to distribute all of the net earnings for the period. “Price- earnings ratio is a multiplier applied to earnings per share to determine current value of the common stock and is influenced by the earnings and sales growth of the firm, the risk or volatility in performance, the debt-equity structure of the firm, dividend payment policy, the quality of management and a number of other factors. Since companies have various levels of earnings per share, price earnings ratios allow for comparison of the relative market value of many companies based on $1 of earnings per share” (Block & Hirt, 2005, p. 9).
A balance sheet provides detailed information of the company’s assets, liabilities, and shareholder’s equity and shows all transactions accumulated since the inception of the company and balance sheet items are based on original cost rather than current market value. Assets are what the company owns that have value and can be converted to cash within a year or normal operating cycle of the company and include plants, trucks, equipment, inventory, trademarks, patents, investments and cash.
Liabilities are financial obligations of the company due in one year or longer term and can include money borrowed from the bank, rent for use of the building, money owed to suppliers for materials, payroll for employees, environmental cleanup costs and taxes owed to government, providing goods and services to customers in the future and bonds. Shareholder’s equity is referred to as capital or net worth or the money that would be left if the company sold all of its assets and paid off all of its liabilities and the leftover money belongs to the shareholders or owners of the company (Block & Hirt, 2005).
Both the income statement and balance sheet are based on an accrual method of accounting, in which revenues and expenses are recognized as they occur regardless of when the actual payment is received and even if the supplies has not been paid. However, a cash flow statement shows a company’s sources and uses of cash or actual cash flow position of the firm including how changes in the balance sheet and income statement affected cash and cash equivalents and breaks down analysis according to operating, investing and financing activities. Cash flow statement excludes transactions that do not directly affect cash receipts and payments such as depreciation and write-offs on bad debts and provides information on the company’s liquidity and solvency and its ability to change cash flows in future circumstances.
The financial manager must understand the institutional structure of the Federal Reserve System, the commercial banking system and economic variables such as gross domestic product, industrial production, disposable income, unemployment, inflation, interest rates, and taxes to assist in the financial decision making process. In addition, the financial manager is responsible for interpreting and using financial statements in allocating the company’s financial resources to maximize profits and the wealth of the company’s shareholders (Block & Hirt, 2005).
“The goal of shareholder wealth maximization must also be consistent with a concern for social responsibility for the company by adopting policies that maximize values in the market; the company can attract capital, provide employment, and offer benefits to the company” (Block & Hirt, 2005, p. 27). The company may also use financial information to make informed and ethical business decisions, for example declining stocks due to immense competition in the telecommunications industry and the shareholders are bemoaning on the returns. The company is under pressure to develop an aggressive approach to cut costs and realize growth by outsourcing some of their jobs and create partnerships with other providers to offer new services. The company must communicate with their loyal employees and shareholders and involve them in the decision making process because of social responsibility and ethical values. Furthermore, financial statements have significant value, but non- financial indications such as employee commitment, customer satisfaction, quality of corporate governance, and operational performance are really the key to the company’s success (Chasan, 2007).
Financial statements including income statement, balance sheet, and cash flow statements provide important information for managers, employees, investors to assist in making informed business decisions. Financial managers must have thorough understanding of accounting principles to allocate the company’s financial resources to generate the highest returns for the company. In addition, the use of financial accounting may be used to make ethical decisions impacting the company’s performance and other stakeholders.