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Financial statements are written financial records of a business entity, which are prepared by consolidating data taken from a business’s accounting system. Financial statements are prepared after the end of every financial period. They serve as method of communication between a business entity and its stakeholders. There are two primary financial statements, which should be prepared by a business entity at the end of every financial period. They include a balance sheet (statement of financial position), and an income statement (profit and loss statement). However, the International Financial Reporting Standard (IFRS) requires that, apart from the aforementioned financial statements, a business entity should also prepare a statement of retained earnings, and a cash flow statement, at the end of every financial year. Every financial statement has its own purposes, in terms of communicating to the stakeholders, both internal and external. All financial statements should conform to the Generally Accepted Accounting Standards (GAAP), during their preparation.
According to Bacak, business entities should always ensure that, their financial statements are accurate. This is because; the significance of accurate financial statements is paramount in a business entity. Bacak refers to financial statements as “windows into the health of a company”. A proficient business owner can be able to determine the strengths, and the weaknesses of a given financial statement, just by looking at it for the first time. This enables business owners to utilize their strengths to minimize their weaknesses, while maximizing their strengths at the same time. Even though every financial statement has its own purpose, the overall purpose of financial statements to a business entity is to meet the needs of its potential and current investors, financiers, owners/manager, employees, and the government.
Purpose of Financial Statements by Business Entities
Investors are individuals or artificial persons (corporate bodies), who invest their money in a business, with expectations of earning positive incomes from their shares. Before making decisions on whether to invest or not to invest in a given company, investors use financial statements to evaluate the financial position, and performance of a company. For instance, investors utilize a balance sheet to determine how a company finances its operations. When a company depends more on borrowed capital than equity capital, it means that the investors may not earn as much as they desire from their investments because, most of the company’s earnings will be used to settle outstanding debts. An income statement provides investors with information regarding the profitability of a company.
Moreover, a statement of retained earnings helps investors to evaluate how a company utilizes its earnings after interest and tax. Investors may look for information such as, what share of retained earnings is distributed to investors in the form of dividends? By utilizing the information provided by the financial statements, current investors are able to decide whether to continue investing or withdraw their stakes, while potential investors are able to decide whether to invest in a given company. Generally, the purpose of financial statements to the investors is to make investment decisions.
The purpose of financial statements by business entities is to meet the needs of the financiers. Financiers, also known as creditors, are those who provide capital to business entities. They usually include financial institutions such as banks and other lending institutions such as savings and credit societies. Financiers utilize the balance sheet, income statement, and cash flow statement, when deciding whether to advance a long-term loan, or to grant new working capital to a business entity. By using a balance sheet, financiers perform ratio analysis to determine the creditworthiness of a given business entity. Liquidity ratios assist financiers to evaluate the ability of a business to meet its current liabilities, using its current assets, continuously. This applies when a business requires its financier(s) to provide it with fresh working capital. Similarly, when a business entity is in need of long-term finance, its financer(s) can use its balance sheet to determine its debt/asset ratio. Debt/asset ratio helps financiers to determine the proportion of a company’s assets that can be used to settle outstanding long-term debts, in case of bankruptcy, or inability of the company to meet its debt obligation on timely basis.
Business owners, in liaison with top management personnel, utilize financial statements in preparation of annual reports to the stakeholders. Financial statements also form part of businesses’ annual reports. For instance, a balance sheet reports the financial position of a company at the end of a given financial period, to the stakeholders. Business owners are also able to evaluate how efficient the business is, in managing its inventory, and in collecting outstanding debts from its clients by analyzing a balance sheet. From the balance sheet, managers can be able to prepare accounts receivable aging report, which can assist in determining the debts that need to be collected urgently (those with an outstanding collection period of more than 120 days). Accounts receivable aging report assists a business entity to maintain a stable working capital throughout an operation period. Liquidity ratios, such as current ratio assist managers to determine the ability of a business to convert its current assets into liquid cash, in order to meet its daily cash requirements. Therefore, financial statements help business owners and managers to anticipate business needs in advance, thus, preventing businesses from suffering from uncertainties.
Financial statements also play a significant role to the employees of any given business entity. While bargaining for salary increments, employees utilize the information provided by the financial statements. For instance, if a company’s income statement indicates increased income from one trading period to another, employees may use this information to bargain for salary increments. Moreover, employees can utilize both the statement of financial position and income statement to defend their demands for promotions, and/or change of job rankings. This is because, these financial statements can be used to determine the financial performance of a business, and forecast about the future of a business. Where such analyses indicate positive performance, employees may then use that information, to discuss with the management about possible promotions or change of ranks, due to improved business performance. In many occasions, labor and trade unions utilize financial statements when making collective bargaining agreements with businesses on behalf of their members. Financial statements, especially the income and the retained earnings statements provide relevant information to labor/trade unions, while making compensation bargains with business owners/managers.
The purpose of financial statement to the government is to determine the tax liability a business owes to the tax authorities. Commonly, businesses are required to pay taxes to the government from their operating incomes: after making the necessary deductions (allowable expenses only). The income statements provide all the information concerning tax properties. They include, total annual revenue, and total expenditures incurred in revenue generation. The net of these two items is used to determine the amount, which a business owns to the government in the form of taxes.
Financial statements may also be useful to other stakeholders who may include vendors/suppliers, and members of the public. Venders/suppliers use financial statements to evaluate the creditworthiness of a business entity before advancing it with good/supplies on credit terms. For instance, by looking at the volume of current assets versus the volume of current liabilities, venders/supplies are able to determine the ability of a business to meet their short-term credit obligations without difficulties. This can be determined by evaluating the current ratio of a business entity. For instance, a current ratio of 2:1 would indicate that a business’s current assets are twice greater than its current liabilities. Therefore, it would be able to meet its short-term credit obligations fully, by converting just a half of its current assets into liquid cash. On the other hand, members of the public use financial statements for various reasons. For instance, public members may determine economic growth of a given industry/sector or of the entire country, by using financial statements of blue chip companies/top performing companies.
The purpose of financial statements to a business entity is to meet the diverse needs of stakeholders. Financial statements provide both the current and potential investors with information concerning the profitability of a business, to assist in determining the viability of their investments. Business owners/managers utilize financial statements to make business decisions concerning liquidity, efficiency of the inventory system, and the efficiency of the debt collection system. When business employees want to make bargains for salary increments, or promotions, or even change of job ranks, they utilize the information provided by the financial statements to discuss their needs with business owners. Similarly, trade/labor unions use financial statements undertake collective bargain agreements with employers on behalf of the employees. Moreover, financial statements provide tax authorities with the necessary information for tax purposes.