Interpretation of Financial Statements

• Author: Vern Krishna
• Pages: 191-215

Chapter VIII: Interpretation of Financial Statements 191

Chapter VIII: Interpretation of

Financial Statements

A. GENERAL COMMENT

We prepare corporate nancial statements for various purposes and

audiences. ey report on the nancial stewardship of an enterprise

based upon historical and, under IFRS, some fair value information

about the entity. Stewardship stops when the report is delivered to

the person to whom the enterprise is accountable — for example,

the trustees of a trust, directors and shareholders of a corporation,

ocials of a regulatory agency, or the tax authorities. However,

there are additional users of nancial statements.

Financial analysts are an important constituency interested in

corporate statements. ey pore over the statements to detect fu-

ture trends and report their ndings to investors, private clients,

and investment media. Indeed, some specialized television chan-

nels — such as, CNBC — do little else other than analyze nancial

information, economic trends, and the general business environ-

ment for their investor-oriented audiences.

Lawyers who are responsible for their clients’ corporate trans-

actions and agreements that contain nancial covenants and re-

strictions are also interested in nancial statements. Lawyers,

acting for creditors, partners, joint venturers, trustee stakeholders

or labour unions, look at the nancial statements and ensure that

they comply with the terms of agreements.

192 Understanding Financial Statements

Management is interested in all aspects and perspectives of -

nancial statements — past, present, and future. ey must ensure

that the statements properly report information as part of their cus-

todial 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 they should steer

the corporation in order to maximize its return on equity to create

wealth for their shareholders.

B. MEASURING FINANCIAL SUCCESS

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

of a business is to maximize its return on equity (ROE) and control

risk, which, requires reliable tools of measurement and analysis.

Absolute numbers are not very helpful in nancial analysis. Ratios

are a better tool to analyze businesses of varying size. For example,

absolute numbers mean little if we are comparing IBM with a small

startup technology company.

Ratios allow us to use a common denominator to measure status

or performance. For example, if one company earns  million in

sales and another has  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 — net

income as a percentage of sales — we obtain a more meaningful

snapshot of the two companies than we would by looking at their

absolute numbers.

We must be careful with numbers analysis. ere is a psycho-

logical tendency to draw comfort from numbers. ere is also a

danger in interpreting numbers as absolutes. ere is no predeter-

mined “good” ratio for nancial analysis. Each situation requires

analysis in the context of the particular business, its environment,

stage of development and the economic climate. us, properly

used, a ratio is an analytical tool for nancial interpretation and

not an end in itself.