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Importance of Financial Statements Targeted at External Users

Paper Type: Free Assignment Study Level: University / Undergraduate
Wordcount: 1652 words Published: 20th Oct 2020

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In the presence of globalization, financial statements have become the standard measurement in judging a company's performance. Financial statements are an overall impression of the company which shows profitability, efficient utilization of assets, settlement of outstanding debts, management of equity and liquidity position to make economic and business decisions by both internal and external users. The analysis of financial statements is the application of financial activities and additional facts of the business, the examination of historical, present and possible result and monetary situation to make investing, financing and commercial decisions (Robinson et al. 2015, financial statement analysis: an introduction, para. 4). Hoggett et al. (2014, pp. 10-11) define external decision makers as potential shareholders, clients, creditors (bank) and tax authority who need a financial record to give decisions about investment, approval of loan application, acquisition of products, and compliance with applicable tax law and regulations. This essay will assess the importance of financial statements to external users in addition to a qualitative factor. The scope of this essay is limited to the importance of three financial statements that is profit and loss statement, statement of financial position and statement of cash flow to potential shareholders (investors) and creditors. First, this essay will explain an overview and usefulness of financial statements. Second, it will highlight the reasons for the importance of financial statements to investors and creditors with the use of ratio. Finally, it will suggest other factors that can influence financial statements in decision making.

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Financial statements record financial and operational data and each statement has a unique feature designed to help especially to external users who do not take part in the daily operation of the business. Among the three statements, profit and loss statement include revenue, expense, and profit. According to Hoggett et al. (2014, p. 40), ‘profit for the period’ is the result of revenue exceed over expenses and there will be a loss occur when expenses exceed revenue. The major function of this statement is to portray whether the company is profitable, can generate enough inflow and allocate costs effectively. Investors and creditors can judge the operation efficiency of a firm by comparing the previous year sales and expenses to this year. Statement of financial position is the second type of financial statements which includes assets, liabilities and equity. Assets and liabilities can be subdivided into short-terms and long-terms. Equity section includes share capital, share premium and retained earnings. The accounting equation is stated by Hoggett et al. (2014, p. 973) as ‘Assets = Liabilities + Equity’. Both potential investors and creditors are interested in the possession of assets, precise amount of debt that the company need to settle. Although income statement and balance sheet show the financial and operational performance, the liquid position of a firm cannot be seen by users. For instance, a firm may get profitable but it may be gone into liquidation for having low or without operating cash. Thus, the actual cash position of the company is presented in statement of cash flow. It helps ‘users’ in analyzing the skills of a firm in generating cash and estimating future cash flow (Hoggett et al. 2014, p. 999). All these statements are beneficial in making sound decision because they present numerical data which is an easy way to translate the health of a company within a short period. For instance, investors can decide whether the company is in profit or loss immediately by seeing the final figure from profit and loss statement. Moreover, these numerical data can transform into an analysis based on the need of users by ratios. Thus, transformation of financial figures to ratios will help investors and creditors in their decision-making process faster.

Interpretation of financial statements by calculating ratios is mainly used by investors and creditors in order to know in depth knowledge about financial statements for making investment and financing decision. The research (Ou and Penman, 1989; Abarbanell and Bushee, 1998) or credit failure (Altman, 1968; Ohlson, 1980; Hopwood et al., 1994) cited in (Robinson et al. 2015, financial analysis technique: ratios, para.2) show that the effective way of choosing investment and forecasting financial risk is computing ‘financial statement ratios. The primary interest of potential shareholders is making investment decision. There are two factors that financial statements are important to potential shareholders. First, they would like to use the statements for deciding whether they should buy the shares of a company. Second, if they invested in the company, they are interested in the return from their investment such as dividend to compare other investment such as saving money into the bank. According to Gowthorpe (2018, pp. 182-183), dividend per share (‘Dividend for the year/number of issued shares’) is the amount of dividend achieved through an ordinary share investment. For example, if the investors buy a share for $100 and the dividend per share is $10, the return per share is 10% per annum. Therefore, investors should invest in that company if the return rate from other investment is less than 10%. The major concern of creditors is the regular repayment of interest and the return on principal when it is due by a company. ‘Debt to equity ratio and interest coverage ratio’ are easy way to access a company’s financial obligations and it is the measurement of debt capital in relation to capital (Robinson et al. 2015, financial analysis technique: interpretation of solvency ratio, para. 4). Robinson also explain that the high result of over 50% means the ability to pay out of debt is low. In this situation, creditors should consider about investing. Furthermore, interest coverage ratio measures the times in interest paid from profit (Gowthorpe 2018, p. 186). If the calculation result shows 5 times, creditors rarely need to worry about the interest repayment by the company which mean that company has enough income to pay off its finance cost. With the development of ratio over time, creditors and investors should not only rely to quantitative factors extract from financial statements but also other qualitative factors.

An alternative to numerical analysis of financial statements is to produce the reliable financial statements and aware of an assumption use in preparing financial statements. Financial statements need to be audited either regulatory requirements or voluntary requirements for creditors and investors and audit opinion is given to users of financial statement with declaration that the fact provided by company is comply with applicable accounting standards and present fairly. (Robinson et al. 2015, financial reporting quality: auditors, para. 1-2). However, due to several changes in auditors, it is difficult to have an opinion of detecting fraud on time pose ‘reporting problems’ (Robinson et al. 2015, evaluating quality of financial report: limited usefulness of auditor’s opinion as a source of information about risk, para. 13). This can lead to creating fraud and misleading information. For instance, ‘window dressing’, defines by Bragg (2018, para. 1), is used to ‘impress’ a sound performance of the company to shareholders who do not take part in the operation of the company and lenders who need a proof to grant a new loan. Thus, they manipulate the statements to look more profitable. For example, sales employees will record sales just before year-end that is before the financial statements are produced to increase sales and they will record back the sales as a sale return after year end in which statements are already produced. This will result in wrong translation of sales and profit of a company by creditors and shareholders.

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In conclusion, financial statements are increasingly critical for investors and creditors for the future. This essay has assessed the importance of financial statements to potential investors and creditors by using quantitative data in conjunction with a qualitative factor. When analyzing the distinctive feature of financial statement, it can be seen that numerical data are not only easy to interpret even by users who has poor knowledge about it but also capture a brief summary of result that is beneficial in decision making. In addition, an interpretation of specific ratios with the use of numerical data presented in financial statements is considerable influence the investment decision of investors and financing decision of creditors.  Finally, to produce a sound decision making, a qualitative factor measuring the reliability of financial statement should be aware. Thus, it is suggested that an internal audit team who know well about the organization should be appointed in order to detect fraud such as ‘window dressing’ early.

Reference list

  • Bragg, S 2018, Accounting Tools, Brag, S, viewed 18 July 2019, .com/articles/what-is-window-dressing-in-accounting.html>.
  • Gowthorpe, C 2018, Business accounting and finance, 4th edn, Cengage Learning EMEA, Andover.
  • Hoggett, J, Edwards, L, Medlin, J, Chalmers, K, Hellmann, A, Beattiee, C & Maxfield, J 2014, Accounting 9E, 9th edn, John Wiley & Sons, Melbourne.
  • Ryan, N n.d., ACCA, viewed 18 July 2019, < https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-exams-study-resources/p5/technical-articles/reward-schemes-for-employees-and-management.html>.
  • Robinson, T, Henry, E, Pirie, W & Broihahn, M 2015, International financial statement analysis, 3rd edn, John Wiley & Sons, Hoboken.


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