Importance of Financial Statements Essay

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Financial statements, also known as financial reports, record the financial activities of a business in short and long term. The four financial statements are: balance sheet, income statement, statement of retained earnings, and statement of cash flows. A balance sheet reports the assets, liabilities, and net equity on a company. An income statement reports income, expenses, and profits on a company. A statement of retained earnings shows a company’s changed retained earnings.The statement of cash flows shows a company’s cash flow activities, such as operating investing, and financing activities (“Financial statements”, 2007, para.

1). Financial statements are very important to a company. There are major purposes of financial statements and the type of information they provide is very important. According to “Financial statements”, “’the objective of financial statements is to provide information about the financial strength, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions’” (2007, Purpose of financial statements, para. ). “Financial statements should be understandable, relevant, reliable, and comparable” (“Financial statements”, 2007, Purpose of financial statements, para.

1). They are directed towards people who understand business and economic activities and accounting (“Financial statements”, 2007, Purpose of financial statements, para. 2). “Owners and managers require financial statements to make important business decisions that affect its continued operations” (“Financial statements”, 2007, Purpose of financial statements, para.

2). These statements are also used as part of management’s annual report to the stockholders” (“Financial statements”, 2007, Purpose of financial statements, para. 2). However, “employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings” (“Financial statements”, 2007, Purpose of financial statements, para. 2). “Prospective investors make use of financial statements to assess the viability of investing in a business” (“Financial statements”, 2007, Purpose of financial statements, para.

). “Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures” (“Financial statements”, 2007, Purpose of financial statements, para. 3). Government entities use them “to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company” (“Financial statements”, 2007, Purpose of financial statements, para.

). Financial statements are used in a variety of ways. There are limitations on financial statements and outside factors upon which the conclusions drawn from these statements are reliant. According to “Limitations”, financial statements have certain limitations: 1. “Historical accounting methods have a tendency to under value the assets of the firm.

2. Different depreciation methods and estimates will report different net income figures in the income statement and different value of assets in the balance sheet. 3.There are certain assets which are not reported in the balance sheet such as the image/reputation of the firm or the value of a firm’s human resources causing the value of the company to appear to be lower than it actually is .

” (“Limitations”, Summary, para. 1) The outside factors upon which the conclusions drawn from these statements are reliant are regularity, sincerity, permanence of methods (coherence and comparison of financial information), non-compensation (full details of financial information), prudence, continuity, and periodicity (“Generally Accepted Accounting Principles”, 2008, Overview, para. ). The limitations and factors are guidelines for a reliable financial statement. Common-size statements are references for corporation or business finances (Tatum, 2008, para. 1).

“In a common-size statement, each of the items in the statement is presented as a percentage of some base” (“Organizational Diagnostics: Financial Statement Analysis, 2003, A First Approach: Common-Size Statements, para. 3). “Balance sheet items are shown as percentages of total assets. Income statement items are shown as percentages of total revenue.Cash flow statement items are shown as percentages of net change in cash” (“Organizational Diagnostics: Financial Statement Analysis”, 2003, A First Approach: Common-Size Statements, para. 3).

Balance sheets, income statements, and cash flow statements are all presented as percentages. Ratios in ratio analysis are computed and used, and most financial analysts prefer ratio analysis to common-size statements. “Various ratios are computed, depending upon the objective of the user analyzing the financial statements” (“Business Definition for: ratio analysis”, 2008, para. ). “Financial ratios can be used to analyze trends to compare the firm’s financials to those of other firms” (“Financial Ratios”, 2007, para.

1). “Construction of common-size statements is useful for some purposes, but most financial analysts devote most of their attention to another approach, ratio analysis” (“Organizational Diagnostics: Financial Statement Analysis”, 2003, The Power Approach: Ratio Analysis, para. 1). “They normalize financial statement data” (“Organizational Diagnostics: Financial Statement Analysis”, 2003, The Power Approach: Ratio Analysis, para. ).

Ratios give information on liquidity, performance of asset utilization, financial leverage, and profitability (“Organizational Diagnostics: Financial Statement Analysis”, 2003, The Power Approach: Ratio Analysis, para. 3-5). Ratios are very important to financial analysts. Financial statements have many purposes. They also provide important information and have limitations. Common-size statements and ratio analysis are used by financial analysts.

However, they both are helpful and useful. Financial analysts have a preference for ratio analysis. References (2007). Financial Ratios”. Retrieved September 14, 2008, from http://www. netmba.

com/finance/financial/ratios (2007). “Financial statements”. Retrieved September 13, 2008, from http://en. wikipedia. org/wiki/Financial_statements (2008).

“Business Definition for: ratio analysis”. Retrieved September 14, 2008, from http://www. allbusiness. com/glossaries/ratio-analysis/4954112-1. htm (2008). “Generally Accepted Accounting Principles”.

Retrieved September 14, 2008, from http://en. wikipedia. org/wiki/Generally_Accepted_Accounting_PrinciplesAxia College of University of Phoenix. (2003). Organizational Diagnostics: Financial Statement Analysis. Retrieved September 14, 2008, from Axia College, Week Three reading, aXcess, HCA 270-Financial Matters for Healthcare Professionals Course Web site.

“Limitations”. Retrieved September 14, 2008, from http://dwc. hct. ac. ae/courses/acct160/new_page_8.

htm Tatum, Malcolm. (2008). “What is a Common-Size Statement? ” Retrieved September 14, 2008, from http://www. wisegeek.

com/what-is-a-common-size-statement. htm

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