Interpretation of Financial Statements

• Author: Vern Krishna
• Pages: 308-332

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Chapter : Interpretation of

Financial Statements

A. OVERVIEW

We have seen that there are four basic nancial statements:

• e balance sheet;

• e income statement;

• e statement of owners’ equity; and

• e statement of cash ows.

We need all four statements for the purpose of corporate analysis. A

missing statement is a red ag.

We use the information in these four statements to analyze the

enterprise’s past economic performance, compliance with legal stew-

ardship, and duciary requirements, and for predicting its future

prospects. Dierent users will focus on dierent measures of past per-

formance. For example, creditors will focus on the enterprise’s ability

to repay its debts, investors will look to predict future performance of

its common stock, and regulators will use the information for regu-

latory compliance. Lawyers use nancial statements in drafting con-

tracts and loan agreements and specify yardsticks for performance.

Financial analysts and advisors are an important constituency

interested in corporate statements. ey pore over the statements

to detect future trends and report their ndings to investors, private

clients, and investment media. Indeed, some specialized television

Chapter 15: Interpretation of Financial Statements 

channels, such as CNBC, do little else other than analyze nancial

information, economic trends, and the general business environment

for their investor-oriented audiences.

Lawyers who are responsible for their clients’ corporate trans-

actions and agreements that contain nancial covenants and restric-

tions are also interested in nancial statements. Lawyers acting for

creditors, partners, joint ventures, trustee stakeholders, or labour

unions look at the nancial statements to ensure that they comply

with the terms of agreements.

Of course, management is interested in all aspects and perspec-

tives of nancial statements, past, present, and future. ey must

ensure that the statements properly report information as part of their

custodial and duciary responsibilities to the corporation and that

the enterprise complies with all of its legal covenants and contractual

arrangements with creditors and regulators. Management must also

make decisions about the direction in which it should steer the cor-

poration in order to maximize its return on equity (ROE) to create

wealth for its shareholders

B. MEASURING FINANCIAL SUCCESS

From a shareholder’s or owner’s perspective, the primary objective of

a business is to maximize its ROE and control risk, both of which

require reliable tools of measurement to facilitate analysis. Absolute

numbers are not very helpful in nancial analysis because they do

not account for the size and scope of the enterprise’s operations. For

example, absolute numbers mean little if we are comparing IBM with

a small start-up technology company. Ratios are a better tool to ana-

lyze businesses of varying sizes.

Ratios use a common denominator to measure status or per-

formance. For example, if one company earns $ million in sales

and another $ million in sales, but both earn $ million in net

income, we must adjust for relative size of the businesses. One has a

rate of return of  percent on sales; the other a return of  percent.

By reducing the numbers to a common ratio, such as, for example,

net income as a percentage of sales, we obtain a more meaningful