Importance of Financial Statements to External Users

In the presence of globalization, financial statements have become the standard measurement in judging a company’s performance. Financial statements are an overall impression of the company which shows profitability, efficient utilization of assets, settlement of outstanding debts, management of equity, and liquidity position to make economic and business decisions by both internal and external users. The analysis of financial statements is the application of financial activities and additional facts of the business, the examination of historical, present, and possible results and monetary situation to make investing, financing, and commercial decisions. External decision makers of an organization are defined as potential shareholders, clients, creditors (banks), and tax authorities who need a financial record to give decisions about investment, approval of loan application, acquisition of products, and compliance with applicable tax laws and regulations. This article will assess the importance of financial statements to external users in addition to a qualitative factor. The scope of this article is limited to the importance of three financial statements that is profit and loss statement, statement of financial position, and statement of cash flow to potential shareholders (investors) and creditors. First, this article will explain an overview and usefulness of financial statements. Second, it will highlight the reasons for the importance of financial statements to investors and creditors with the use of ratios. Finally, it will suggest other factors influencing financial statements in decision-making.

Importance of Financial Statements to External Users

Financial statements record financial and operational data and each statement has a unique feature designed to help especially external users who do not take part in the daily operation of the business. Among the three statements, the profit and loss statements include revenue, expense, and profit. ‘Profit for the period’ is the result of revenue exceeding expenses and there will be a loss occurring when expenses exceed revenue. The major function of this statement is to portray whether the company is profitable, can generate enough inflow, and allocate costs effectively. Investors and creditors can judge the operation efficiency of a firm by comparing the previous year’s sales and expenses to this year’s. A statement of financial position is the second type of financial statement which includes assets, liabilities, and equity. Assets and liabilities can be subdivided into short-term and long-term. The equity section includes share capital, share premium, and retained earnings. The accounting equation is stated as ‘Assets = Liabilities + Equity’. Both potential investors and creditors are interested in the possession of assets, and the precise amount of debt that the company needs to settle. Although the income statement and balance sheet show the financial and operational performance, the liquid position of a firm cannot be seen by users. For instance, a firm may get profitable but it may be gone into liquidation for having low or without operating cash. Thus, the actual cash position of the company is presented in the statement of cash flow. It helps ‘users’ in analyzing the skills of a firm in generating cash and estimating future cash flow. All these statements are beneficial in making sound decisions because they present numerical data which is an easy way to translate the health of a company within a short period. For instance, investors can decide whether the company is in profit or loss immediately by seeing the final figure from the profit and loss statement. Moreover, these numerical data can transform into an analysis based on the need of users by ratios. Thus, the transformation of financial figures to ratios will help investors and creditors in their decision-making process faster.

Interpretation of financial statements by calculating ratios is mainly used by investors and creditors in order to know in-depth knowledge about financial statements for making investment and financing decisions. The financial analysis technique: ratios, is considered one of the effective ways of choosing investments and forecasting financial risks. The primary interest of potential shareholders is making an investment decision. There are two factors that financial statements are important to potential shareholders. First, they would like to use the statements for deciding whether they should buy the shares of a company. Second, if they invested in the company, they are interested in the return from their investment such as dividends to compare other investments such as saving money in the bank. Dividend per share (‘Dividend for the year/number of issued shares’) is the amount of dividend achieved through an ordinary share investment. For example, if the investors buy a share for $100 and the dividend per share is $10, the return per share is 10% per annum. Therefore, investors should invest in that company if the return rate from other investments is less than 10%. The major concern of creditors is the regular repayment of interest and the return on principal when it is due by a company. ‘Debt to equity ratio and interest coverage ratio’ is an easy way to access a company’s financial obligations and it is the measurement of debt capital in relation to capital. The high result of over 50% means the ability to pay out of debt is low. In this situation, creditors should consider investing. Furthermore, the interest coverage ratio measures the times in interest paid from profit. If the calculation result shows 5 times, creditors rarely need to worry about the interest repayment by the company which means that the company has enough income to pay off its finance cost. With the development of ratios over time, creditors and investors should not only rely upon quantitative factors extracted from financial statements but also other qualitative factors.

An alternative to the numerical analysis of financial statements is to produce reliable financial information and be aware of an assumption used in preparing financial statements. Financial statements need to be audited either by regulatory requirements or voluntary requirements for creditors and investors and an audit opinion is given to users of financial statements with the declaration that the fact provided by the company is complying with applicable accounting standards and present fairly. However, due to several changes in auditors, it is difficult to have an opinion of detecting fraud on time poses ‘reporting problems’. This can lead to creating fraud and misleading information. For instance, ‘window dressing’, is used to ‘impress’ a sound performance of the company to shareholders who do not take part in the operation of the company and lenders who need proof to grant a new loan. Thus, they manipulate the financial statements to look more profitable. For example, sales employees will record sales just before year-end that is before the financial statements are produced to increase sales and they will record back the sales as a sale return after year-end in which statements are already produced. This will result in the wrong translation of sales and profit of a company by creditors and shareholders.

In conclusion, financial statements are increasingly critical for investors and creditors in the future. This article has assessed the importance of financial statements to potential investors and creditors by using quantitative data in conjunction with a qualitative factor. When analyzing the distinctive feature of financial statements, it can be seen that numerical data are not only easy to interpret even by users who have poor knowledge about it but also capture a brief summary of results that is beneficial in decision making. In addition, an interpretation of specific ratios with the use of numerical data presented in financial statements considerably influences the investment decision of investors and financing decisions of creditors.  Finally, to produce sound decision-making, a qualitative factor measuring the reliability of financial statements should be aware. Thus, it is suggested that an internal audit team who knows well about the organization should be appointed in order to detect fraud such as ‘window dressing’ early.

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