1. A company’s financial statements consist of the balance sheet, income stateme
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Question
1. A company’s financial statements consist of the balance sheet, income statement, and statement of cash flows. Describe what each statement tells us and their limitations.
2. What is the purpose and importance of financial analysis? What are financial ratios? Describe the “five-question approach” to using financial ratios. What are the limitations of financial ratio analysis? If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?
Explanation / Answer
(1)
(a) Income Statement gives us the revenue & expenses during a period, and the net profit as the difference between revenue & all expenses. Purpose of this statement is to provide investors with information about whether the company made profits or made losses in a period.
However, Income Statement has several limitations as follows:
- The accounts reflect the accounting rule-based accounting but not actual cash flows. But very often, there can be a timing mismatch between revenue & its associated cash flow, or costs or its associated cash flow. Therefore, profit does not indicate available cash flow.
- Accounting is done based on various accounting standards & principles, which leave room for judgments, estimates & choice of accounting standards (like US-GAAP v/s IFRS)
- Earnings management is a method used by accounting managers to compromise the data, to meet their targets. Thus the statement may reflect underestimated or overestimated account balances.
- It is prepared using historical (past) information & so it is not forward looking.
(b) Cash Flow statement
As mentioned above, Income statement is prepared based on accrual principle where actual revenue/costs do not match the cash flows. But the Cash flow statement (CFS) captures this, by showing the cash inflows & outflows during a period, by categorizing such flows under 3 different heads (based on nature of flows): Operating, Investing & Financing. Sum total of these 3 cash flows provide a snapshot of actual cash situation of the business.
Limitations of CFS are as follows:
- CFS is prepared by Cash basis of accounting vis-a-vis the accrual basis.
- CFS does not let insights into actual profitability of a business, because it excludes important non-cash expenses (like depreciation).
(c) Balance sheet (BS):
Balance sheet provides a snapshot into a company's assets & liabilities at a particular point of time. So it is a Stock concept compared the the Flow concepts of Income statement & CFS. By looking at the BS, one can assess the asset-liability situation of a business.
Its limitations are:
- Based on historical data.
- Some BS items are based on judgment & estimates, for example fixed asset depreciation depends on choice of depreciation rate & useful life.
- Non-financial assets are not included, like intellectual property rights or human capital, which gives valuable contribution to business.
(2)
(a) Purpose of financial analysis is to look inside a company's financial performance & drilling down the components of financial reports, to understand the financial snapshot. This is by far the most valuable method of analyzing a company's past & current performance, as well as future performance projections. This analysis provides useful insight to a company's stakeholders, like customers, suppliers, lenders & investors.
(b) Financial ratios are financial performance measurement metrics using which one can assess how a business is faring.
(c) The 5-question approach is to categorize a firm's financial performance indicators by asking following questions:
1. How profitable is the firm?
2. How liquid is the firm's assets & liabilities situations?
3. How efficiently is the firm utilizing its capital?
4. How much of the firm's capital is comprised of debt, and how much of ownership capital?
5. How solvent is the firm, and is it near bankruptcy?
(d) Ratio analysis limitations are as follows:
- Based on historical data
- A ratio in isolation is meaningless unless it is compared to another ratio.
- Ratio data are subject to judgment & choice of estimates and accounting principles.
- Ratios provide historical performance snapshot & not forward looking. so one cannot understand a firm's prospect going forward.
- Exclusion of valuable qualitative information like management expertise, human capital, IPR or core competencies are not captured by any ratio.
NOTE: It is multipart question with 6 sub-questions, out of which 5 questions have been answered.
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