Financial Statements as Decision-Making Tools

Financial statements of a company or individual are the documents that reflect the historic financial information of the entity. This includes a detailed and accurate record of the assets and liabilities as well as the income and expenses and also the cash flow of the entity. These documents are written records that quantitatively explain the health of unit represent in the statements.

The Financial Statements

Financial statement as communications medium to investors provides a valuable summary of the entities economic history. To the informed these are useful tools to establish the historic performance as well as the future potential of the entity.
The financial statements that will be discussed in this article are:

• The Balance sheet - This document is a quantitatively summary of the assets, liabilities and net worth of the entity at a specific point in time.
• The Income statement - This document provides an accurate accounting record of the sales, income and expenses resulting in the net profit for the reporting period.
• The Cash Flow statement - This is a record of the sources and application of funds that includes operating, investment, and financing activities and how they impacted on the cash position during the reporting period.

The Purpose of Financial Statements

The primary purpose of financial accountants are to provide appropriate information in a standardized format for the taking of financially based decisions. For this purpose the financial statements generally follows a standardized structure.

The financial statements are a record of the activities but do not provide any evaluation of the data. Despite the important role of the financial statements they do not provide an evaluation of the accounting results. In order to be able to use the information contained in the various financial statements for financial decision-making, a number of measurements and evaluations needs to be made to the numbers. Only then will the information be useful as a tool for decision-making.

The Purpose of Measurement and Evaluation

The purpose of the conducting measurements and making evaluation is to provide answers to the following questions:

• Why there are no excess funds available?
• Are the reporting entity financially sound?
• Would it be possible to make further loans?
• Will available cash generating be sufficient to provide in the anticipated demand?

The format and type of information obtained during this process will depend on the intended users of the information.

Interpreting the Numbers

Conducting measurements and the evaluation process basically consists of the rearranging of the information in order to obtain information in a format that can be used to appraise the performance, activities, financial health, stability and growth potential.

In order to conduct a proper evaluation and interpretation of financial statements the following important steps needs to be followed.

• Conduct a superficial analysis of the financial statements in order to obtain an initial feeling for the areas that needs special attention.
• Conduct an evaluation of the flow of funds in order to establish the ability of the entity to generate cash as well as the needs for funds.
• Conduct a ratio analysis in relation to the Rentability also sometimes called profitability, risk and growth. Rentibility refers to the profit or return derived from the differential advantage gained by the company by the application of funds. It is often also referred to the return on investment.
• Analysis of non-financial information.

The interpretation of the information obtained from the calculated ratios should be done cautiously. The primary advice in this regard is to consider the trends over a number of accounting periods rather than the absolute values of specific ratios. In addition to this the overall behavior of groups of ratios should considered non-mechanistic manner to reach conclusions.

Conclusion

From the above introduction to financial statements it is clear that not all the information necessary to make sound financial decisions are readily available form these statements. A number of ratios need to be calculated and compared with others to enable the decision maker to draw the correct conclusions. It should be remembered that the financial statements reflect the historic activities and that decisions are taken about the future. This can only be done by drawing conclusions about trends of the different ratios rather than the actual historic numbers.

© 2009 Carl Marx