Financial statements: Measuring a company’s fiscal fitness

May 13 2014, 08:58 IST
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SummaryA financial statement is essentially a company's report card, which helps stakeholders assess the firm's fiscal health.

A financial statement is essentially a company's report card, which helps stakeholders assess the firm's fiscal health. Stakeholders include shareholders, regulatory bodies such as Sebi, stock exchanges, registrar of companies, banks, government, employees and experts.

It is essential for every stakeholder to understand financial statements. Of course, the objective of each stakeholder is different. Let us look at financial statements in a non-conventional way, from the point of view of prospective investors.

What are financial statements?

They are essentially the financial information of a firm, consisting of audited profit and loss accounts, balance sheet and cash flow statement. They also contain additional disclosures such as management discussion and analysis and corporate governance report.

Focus on cash flow than profit

Profit and cash flow are not equivalent. Profit or loss represents the difference between the prices at which goods or services are provided to customers and the expenses incurred to provide those goods and services.

In addition, profit or loss includes other income such as interest income or income from the sale of items other than goods and services. Although profitability is vital, cash flow is more important because the company needs cash to pay its employees, suppliers in order to continue. A company that generates positive cash flow from operations has more flexibility in funding needed for investments and can take advantage of attractive business opportunities.

Apart from that, the company also needs cash to pay returns in the form of interest and dividends to the providers of debt and equity capital. Therefore, the expected magnitude of future cash flows is important in determining the company’s ability to meet its obligations.

Financial notes and supplementary schedules

The notes often referred as footnotes that accompany financial statements. The notes provide information essential in understanding the information provided in the financial statements. These notes disclose the basis of preparation of the financial statements, information about accounting policies, methods and estimates used to prepare them. As there is flexibility in the accounting choices of firms, a company will select the policies, methods and estimates that are permissible and reflect the unique economic environment of the company’s business and industry.

Often, investors compare two or more companies. It is essential to be aware of the differences in accounting choices among them, which could be easily obtained and understood by looking at the footnotes and supplementary schedules. The footnotes normally discuss about risks arising from financial instruments,

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