Business, Accounting and Financial Studies | Uses of Financial Statements

BAFS Study Notes: Uses of Financial Statements

Hello! Welcome to your study notes for "Uses of Financial Statements". Think of a company's financial statements (like the Income Statement and Statement of Financial Position) as its school report card. They are packed with numbers that tell a story about how well the company is doing.

In this chapter, we're going to become detectives! We'll figure out who reads this "report card", what they are looking for, and why these reports, while super useful, don't always tell the whole story. Understanding this is a key skill, whether you want to be an accountant, run your own business, or just make smart investment choices one day!

Part 1: Who's Reading the Company's Report Card? (The Users)

Lots of different people are interested in a company's performance. We can split them into two main groups: Internal Users (the insiders) and External Users (the outsiders).

Analogy Time! Imagine you are the student. You and your tutor are the internal users of your report card - you use it to plan how to improve. Your parents, the university admissions office, and a scholarship committee are the external users - they use it to make decisions about you from the outside.

Internal Users (The Team Inside)

These are the people working inside the business who need information to make daily decisions.

• Owners / Management: They are the captains of the ship! They use financial statements to:

  • Plan for the future: Should we open a new branch next year? Can we afford to?

  • Control operations: Are our electricity costs too high compared to our sales?

  • Evaluate performance: Did we make more profit this year than last year? Was our new marketing campaign successful?

  • Make strategic decisions: Should we continue selling a product that is barely making a profit?

External Users (The World Outside)

These are individuals and organisations outside the company who have an interest in its financial health.

• Investors (Existing and Potential): These are people who have bought or are thinking of buying shares in the company. They want to know:

  • Is the company profitable? Will I get a good return on my investment (e.g., dividends)?

  • How risky is the investment? Is the company financially stable?

  • Their Big Question: Should I buy, hold, or sell the company's shares?

• Lenders / Creditors (e.g., Banks and Suppliers): These are the people the company owes money to. A bank that gave a loan or a supplier who sold goods on credit wants to know:

  • Can the company pay its debts as they become due? This is called liquidity and solvency.

  • Is it safe to lend them more money or continue selling to them on credit?

  • Their Big Question: Will we get our money back?

• The Government (e.g., Inland Revenue Department): The government needs to know:

  • How much profit did the company make, so they can calculate the correct amount of profits tax.

  • Is the company following all the rules and regulations?

  • Their Big Question: Is the company paying its fair share of taxes?

• Employees: The staff of the company are also very interested. They look at the statements to assess:

  • Job security: Is the company stable, or is it at risk of closing down?

  • Pay rises and bonuses: Can the company afford to give them a raise or a year-end bonus?

  • Their Big Question: Is my job safe and does the company have a good future?

• Customers: Especially for big purchases, customers might care about the company's health. They want to know:

  • Will the company be around to honour warranties or provide after-sales service?

  • Can the company be a reliable long-term supplier?

  • Their Big Question: Can I rely on this company in the future?

Key Takeaway - Part 1

Financial statements are not just for accountants! They provide crucial information for a wide range of users, both inside and outside the company, to make important economic decisions.

Part 2: Why These Statements Are So Useful

So, we know who reads the statements. Now let's look at exactly how they help in decision-making.

• Assessing Performance: Users can see if a company's profit is growing or shrinking over time. They can analyse where the money is coming from and where it's going. For example, by comparing the Income Statements for 2022 and 2023, an owner can see if sales have increased and if costs have been controlled.

• Making Investment Decisions: By looking at profitability and the company's assets and liabilities, investors can judge whether it's a wise place to put their money.

• Making Credit Decisions: Banks won't just lend you money because you ask nicely! They will carefully study your Statement of Financial Position to see if you have enough assets to cover your debts, ensuring you are likely to repay the loan.

• Planning and Budgeting: Management uses past results to create future budgets. If last year's financial statements show that the electricity bill was very high, the manager can budget for new energy-saving lights this year.

• Ensuring Compliance: For limited companies, it is a legal requirement to prepare and publish financial statements. They are essential for filing tax returns and proving the company is operating legally.

Did You Know?

Publicly listed companies in Hong Kong (those you can buy shares of on the stock exchange) must publish their financial statements regularly. This means anyone, including you, can go online and look up the "report card" for huge companies like HSBC or MTR!

Key Takeaway - Part 2

Financial statements are a powerful tool for evaluating past performance, managing current operations, and planning for a company's future.

Part 3: The Limitations - Why Statements Don't Tell the *Whole* Story

This is a super important section! A-grade students know that financial statements have blind spots. It's crucial to understand what they *can't* tell us.

Don't worry if this seems tricky at first. Thinking about these limitations shows you have a deep understanding of accounting.

• They are based on the past: Financial statements are historical. They tell you how a company performed last year, but they don't guarantee future success.
  Analogy: It's like driving a car while only looking in the rear-view mirror. It tells you where you've been, but not what's coming up on the road ahead.

• Non-monetary information is ignored: The statements only show things that can be measured in money. They can't measure crucial factors like:

  • The skill of the management team

  • Employee morale and happiness

  • Customer satisfaction and brand reputation

  • The quality of the company's products

  A company could have high profits but terrible staff morale, which might cause problems in the future. The numbers alone won't show this.

• Different accounting policies can be used: Companies sometimes have a choice of accounting methods (e.g., different ways to calculate depreciation). This can make it difficult to compare the financial statements of two different companies directly.
  It's like comparing the exam results of two students when one was allowed to use a dictionary and the other wasn't. The comparison might not be fair.

• The impact of inflation is ignored: Items are usually recorded at their historical cost (what was paid for them). This doesn't account for inflation, which reduces the purchasing power of money over time.
  For example, a building bought for $2 million in 1995 might be worth $30 million today, but the Statement of Financial Position might still show it at a value close to its original cost.

• Possibility of "Window Dressing": This is a key term! Window dressing is when management legally manipulates the figures to make the company look more attractive, especially at the end of an accounting period.
  An example would be delaying payment to suppliers just before the year-end to make the cash balance look higher. It's like quickly tidying your room just before a guest arrives – it looks good for a moment, but it doesn't reflect the everyday reality!

Key Takeaway - Part 3

While essential, financial statements have limitations. They are historical, ignore non-financial factors, and can be influenced by accounting choices. A smart user always reads them with a critical eye and looks for more information.

CHAPTER QUICK REVIEW

1. Users of Financial Statements:
- Internal: Management/Owners (for planning, control, and decision-making).
- External: Investors (buy/sell shares?), Lenders (lend money?), Government (tax?), Employees (job security?).

2. Uses of Financial Statements:
- To assess past performance.
- To help make investment and credit decisions.
- To assist in planning and budgeting.

3. Limitations of Financial Statements:
- Historical Data (based on the past).
- Ignores Non-monetary Items (e.g., staff morale).
- Different Accounting Policies (hard to compare).
- Inflation is Ignored (historical cost).
- Window Dressing (can be misleading).
Memory Aid: Try to remember the limitations with the mnemonic H I D I W!

You've got this! Understanding the 'who', 'why', and 'what's missing' of financial statements is a fundamental skill in BAFS. Keep reviewing these points, and you'll be an expert in no time.