The primary purpose of financial statements is to provide a medium by which the directors can report to the shareholders on the performance of the company concerned. The financial statements are, however, frequently used by other interested parties, such as lenders, creditors, potential investors, tax authorities and the government to help them assess their returns and the risk that they may face. This section explains the purpose and format of the three main financial statements the balance sheet, the income statement (profit and loss account) and the cash flow statement that are essential for any managemnet consultant and how it relates to the operations of a company.
1. The balance sheet
The balance sheet shows the position the business is in at a specific point in time, the assets it holds at that date and the liabilities it has. We need to understand the format, terminology and valuation rules applied to understand what we are seeing when we examine a company’s accounts.
2 The accounting treatment of financial instruments
One of the most difficult issues in recent years has been the treatment of financial instruments, the issue largely arising from derivatives were, from a position that may have had a negligible cost, a very large loss can arise. When analysing companies we need to understand this potential.
3. The income statement and statement of changes in equity
The income statement shows how the business has generated profits across the period, typically a year, allowing us to see how the business is performing.
4. The cash flow statement
The primary cause of corporate failure is not the lack of profits but the lack of cash to service liabilities as they fall due. The cash flow statement details the cash generated by a business and provides an indication of potential liquidity issues.
5. Group accounts
Most major businesses are not individual companies but are groups of companies acting together under the control of a holding company. We need to understand how group accounts are constructed and what additional characteristics arise in a group context.
6. Major accounting ratios
Finally, we need to appreciate how these various statements may be used by investors to assess the potential returns and areas of potential risk exposure arising from how the business is trading or how it is financed. In looking to assess potential returns and risks, ratios may be used by analysts to compare a company’s performance against its past period performance, and when comparing a company against similar companies within the same industry. Ratios help condense down information into an easily understandable figure.
Ratios may be broadly defined under profitability, liquidity, financial gearing and investor ratios, this latter category largely being considered under equity later in this Study Text. Information to be used in ratios may be obtained from the balance sheet, the profit and loss account, or the cash flow statement, hence it is essential that we understand what these statements are telling us and how they are linked.