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, commitments and contingencies, legal proceedings, related-party transactions, business acquisitions and disposals, which are essential elements for an investor.
Management discussion and analysis
All firms typically include a section in their annual reports where the management discusses a variety of issues such as nature of the business, industry structure and development, opportunities, threats, past results, future outlook, risk and concerns. The discussion by the management is arguably one of the most useful parts of a company’s annual report apart from financial statements. However, other than excerpts from financial statements, information included in the management commentary is typically unaudited.
Financial statements presented in companies’ annual reports are required to be examined by an independent accounting firm as per the specified standards. The independent auditor then provides a written opinion on the financial statements. An unqualified audit opinion states that financial statements give a ‘true and fair view’ and are ‘fairly presented’ in accordance with applicable accounting standards.
This is known as a ‘clean’ opinion. Alternatively, a ‘qualified audit opinion’ is one in which there is some scope of limitation or exception to accounting standards. An adverse audit opinion is issued when an auditor determines that financial statements materially depart from accounting standards and are not fairly presented.
To conclude, when looking at the financial statements, investors should review the company's sources of information, economy, industry and the comparable firms in order to assess the company’s future.
The writer is an associate professor of finance and accounting at IIM Shillong