The Importance of Financial Statements - Essay Example

Running head: Financial analysis ment Introduction Financial ments are very important for a business entity to be successful; they can be used to show the strengths of the company and its weaknesses too. Investors such as the shareholders, debenture holders and other providers of capital, usually analyze the financial statements of a company before committing their funds to the company so as to assess the company’s performance and profitability levels. The statements usually include ratios such as the profitability ratios, liquidity ratios, activity ratios and the leverage ratios (Jiambalvo, 2001). Ratios They are used to describe the correlation between two figures, single ratios in most cases do not give ample information thus they should be compared for a couple of years so that the analyst can be in a position to identify the trend emerging from the ratios, this enables the analysts and the investors to make sound decisions concerning the company. The profitability ratios can be categorized into the following categories: return on equity (ROE), rate of return, and return on investment (ROI), dividend yield and dividend payout ratio. Both return on investment and return on equity are derivatives of the income statement and are based on the net income as a balance sheet element (Jiambalvo, 2001). The rate of return is very important to the investors as they look at an investment’s rate of return to be able to compare the available investments opportunities. The investors will invest in the projects with higher rates of return and are associated with a low risk. The ratio of return on investment is used as an indicator that shows the effectiveness of the management. This is due to the fact that, it shows the rate of return the management of the business entity were able to attain on the available assets of the business. The ratio on return on equity, basically measures the profitability of the company. This ratio is expressed as a percentage of net income dividends by the average of the investor’s equity in the period during which the investor earned the net income The price earning per share (P/E), dividend payout ratios and dividend yield ratios are also important ratios. The earnings per share is a very popular with market analysts and investors in order to evaluate the prevailing market prices of the shares and determine whether they are under or over valued. Thus incase the shares are under valued and thus are trading at a lower price in the stock markets, the investors will invest more in such shares and will shy away from over valued shares. The ratios on dividend yield are used by the analysts and investors to compare various investments and to evaluate them so as to identify the investment that meets their objectives, and thus they will invest in those investments that best meet their investment goals. The dividend payout ratio indicates the policy of a company in paying dividends to its shareholders. Most companies use certain policies to pay dividends; the dividends are paid on a specified percentage. When an investor knows the pay out ratio, such an investor is in a position of projecting dividend income in future by use of the projected earnings of the company together with the ability of the company to consistently earn profits, enough to pay dividends or increase its target of dividend pay out (Jiambalvo, 2001). The liquidity ratios are mainly classified into working capital ratio, the current ratio and the acid test/ quick ratio. These ratios show the ability of a company to pay its current liabilities. The acid test ratio is a short term which only includes only the cash available to the company and also the accounts receivables and payables and thus excludes stock although it is a current asset. This ratio therefore, shows the ability of a company to settle its outstanding debts without affecting its stocks. The working capital which basically the difference between the current assets and the current liabilities is not as important as the current ratio since it only reports a figure without any reference and thus such figures are not very significant to decision makers. Generally an acid test ratio of 1 and a test ratio of 2 can be used as indicators to show that the liquidity of the company is okay (Jiambalvo, 2001). The levels of activity in a company are also used as ratios, the most commonly used ratios to determine the level of activity are; turnover ratios, day sales for inventory and accounts receivable. In most cases analysts use both financial measures and physical measures in developing statistics and identification of trends, so as to be able to compare results for some period. The turnover rate is used as a measure of efficiency and determines how effectively the assets of the company have been used to generate revenue. Turnover therefore, simply relates the level of sales to that of the assts. The efficiency in the management of assets can also be determined by use of turnover on the accounts receivables and for inventories. For accounts receivables, the sooner the debts are collected the better as more cash will be available for use in the company and therefore less cash will have to be borrowed to settle liabilities. For the case of the inventories, the lower they are maintained as compared to sales, the less investment is required for them and thus the company avoids investing heavily on stocks. The leverage ratios mainly consider the financial leverage of a company, that is, the extent to which a company uses debt in order to finance its acquisition of assets. The leverage ratios mainly include the debt ratio and the times interest earned ratio. Company’s that are highly levered are at a greater risk of incurring losses in case the return on investment is lower than the borrowing cost. Thus it is very important for a company to restrict its amount of debt so that it does not go beyond a certain percentage. The ratio of times interest earned is mostly used by the long debt holders. This ratio indicates the link between earnings before taxes and interests are deducted and the expenses on interest (Jiambalvo, 2001). Limitations of financial statement analysis All the financial statements are based on the past data and information to assist the creditors and investors to be able to predict the performance in future of a company or to assess the company’s ability to generate cash flows in future. However, past data and information might not necessarily be very relevant in the future and hence the investors and the analysts might make serious mistakes when using such information to make vital investment decisions. Some items with very relevant information but which cannot be adequately measured are not reported in the financial statements such information would include brand loyalty and recognition. Some of the figures used in the financial statements can be obtained from use of subjective methods and thus might not provide the essential information required when making an investment decision (Jiambalvo, 2001). Conclusion For investment purposes analysis of the financial statements of a company is very important as it provides the necessary information to assist the investors make sound decisions before committing their funds to a certain investment. This analysis also assists the management of the company to take the necessary measures as far as investment is concerned and thus companies are able to survive in the long run. Financial statements cannot be used isolation and they therefore have to be compared with all other financial statements in order to make good investment decisions. Reference: Jiambalvo, James (2001): Analyzing financial statements: a managerial perspective, Retrieved on 12th May from, http://www.wiley.com/legacy/college/bcs/0471238236/financial/ch11.pdf. Read More