Interpretation of Financial Statements

AuthorVern Krishna
Chapter : Interpretation of
Financial Statements
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
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

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