Financial statements are an essential source of financial information for a wide range of users and decision-makers. These statements provide a comprehensive overview of a company’s financial position, performance, and cash flows.
Users rely on financial statements to make informed decisions about a variety of matters, including:
Present and potential owners (investors) are prime users of financial statements. They continually assess and compare the prospects of alternative investments. The assessment of each investment is often based on two variables: expected return and risk.
Expected return refers to the increase in the investor’s wealth that is expected over the investment’s time horizon. This wealth increase is comprised of two parts:
- increases in the market value of the investment and
- dividends (periodic cash distributions from the firm to its owners).
Both of these sources of wealth depend on the firm’s ability to generate cash. Accordingly, financial statements can improve decision-making by providing information that helps current and potential investors estimate a firm’s future cash flows.
Risk refers to the uncertainty surrounding estimates of expected return. The term expected implies that the return is not guaranteed. For most investments, numerous alternative future returns are possible. For example, an investor may project that a firm’s most likely return for the upcoming year is $100,000. However, the investor recognizes that this is not the only possibility.
There is some chance that the firm might generate returns of $90,000 or $110,000. Still, other possibilities might be $80,000 and $120,000. The greater the difference among these estimates, the greater the risk. Financial statements help investors assess risk by providing information about the historical pattern of past income and cash flows.
The lending decision involves two issues: whether or not credit should be extended and the specification of a loan’s terms. For example, consider a bank loan officer evaluating a loan application.
The officer must make decisions about the amount of the loan (if any), interest rate, payment schedule, and collateral. Because repayment of the loan and interest will rest on the applicant’s ability to generate cash, lenders need to estimate a firm’s future cash flows and the uncertainty surrounding those flows.
Although investors generally take a long-term view of a firm’s cash-generating ability, creditors are concerned about this ability only during the loan period.
Lenders are not the only creditors who find financial statements useful. Suppliers often sell on credit, and they must decide which customers will or will not honour their obligations.
Management: Management uses financial statements to track the company’s performance, identify areas for improvement, and make informed decisions about resource allocation, pricing, production, and investment.
Government Agencies: Government agencies, such as the Securities and Exchange Commission (SEC), use financial statements to regulate companies and ensure that they are complying with accounting standards and securities laws.
Employees: Employees use financial statements to assess the company’s financial health, job security, and potential for future growth. They also use this information to make decisions about whether to continue working for the company or seek employment elsewhere.
Suppliers: Suppliers use financial statements to assess a company’s creditworthiness and ability to pay for goods and services. They use this information to make decisions about whether to extend credit to the company and what payment terms to offer.
Customers: Financial statements are a crucial tool for customers to evaluate a company’s financial health, credibility, and capability to carry out its responsibilities. By examining financial statements, customers can make informed decisions about whether to maintain their business relationship with a company or seek alternatives elsewhere. In essence, financial statements provide customers with transparency and insight into a company’s financial performance, which is vital for building trust and maintaining a positive business relationship.
In addition to these primary users, there are many other stakeholders who may rely on financial statements, such as analysts, researchers, and members of the public. Financial statements provide a valuable source of information for anyone who wants to understand the financial condition and performance of a company.