Financial statements are a valuable source of information about a company, regardless of its size and type. Financial statements provide data concerning the company’s business and financial health. Hence, a variety of stakeholders can use financial statements to gain more insight into the company’s performance. Whereas internal stakeholders, such as the management, can use financial statements to assess possible cost-cutting opportunities and gain insight into the firm’s efficiency, external stakeholders use financial statements to make investment decisions or conduct due diligence. Financial statements provide comprehensive information about the company’s sales, costs, assets, debts, and other crucial financial measures.
Thus, improving knowledge and understanding of financial statements is vital to ensuring their proper use. This paper aims to discuss the various users of financial statements and examine how financial analysis can help in conducting due diligence and evaluating the firm’s financial health.
Users of Financial Statements
Company managers and leaders are the critical internal users of the company’s financial statements (Wahlen, Baginski, & Bradshaw, 2014). For this group of users, financial statements provide strategically important information on firm performance. For example, managers can use financial statements to analyze the company’s profitability after a major organizational change to evaluate its effect on performance.
Also, financial statements are crucial for improving profits, as they provide a useful way of identifying excessive spending (Wahlen et al., 2014). Managing the costs is an essential part of business success, as it helps to improve efficiency and gain more net profits. Thus, financial statements are useful for leaders and managers because they help to measure effectiveness and performance.
Shareholders of the company are also among the key groups interested in financial statements. The financial performance of the company is critical to the stakeholders as it determines their profits or losses. Thus, shareholders can use financial statements to determine if the company is healthy and if it is worthwhile to keep its shares. Furthermore, shareholders might use financial statements when making strategic decisions about the company and its future development.
Another group of internal stakeholders that can benefit from evaluating financial statements is its employees. Regular employees need to keep track of the company’s performance to predict any substantial changes and ensure that their job is secure. Analysis of financial statements can indicate if the company is underperforming or if it is profitable enough to offer development opportunities to its workers.
The range of external stakeholders that might take an interest in the company’s financial performance is rather broad. The key groups of external stakeholders that use financial statements in decision-making are creditors, suppliers and vendors, auditors, and potential investors. Generally, in their assessment of the company’s financial statements, these groups aim to develop an understanding of the firm’s overall financial health and to determine if there are any issues with regards to returns, liquidity, or other important factors (Wahlen et al., 2014). For example, balance sheets are often used by creditors to determine if the company is likely to pay back the loan.
As noted by Nicoară (2015), the balance sheet allows stakeholders to judge the overall health of the company by picturing its assets, liabilities, and equity. If the company’s assets are significantly smaller than its liabilities, the creditors will usually deny the request for a loan as the company might not be able to repay it. An income statement, on the other hand, can be used by potential investors to make projections about the company’s future and return on investment, thus aiding in decision-making (Marchini & D’Este, 2015). Analyzing the company’s income statements over several years can help to understand its growth and outline problem areas that could affect the return on investment.
Another important group of stakeholders includes the company’s suppliers and vendors. In most cases, the financial stability and performance of suppliers and sellers largely depend on the performance of the company itself. Thus, suppliers and vendors might use financial statements when deciding to enter a contract. In some cases, the company’s financial statements might also become a focus of attention of legal workers, especially if the company or its workers are suspected of fraudulent activity (Lehman Brown, 2014).
In this case, the analysts will usually look for inconsistencies in the firm’s balance sheets or income statements. Inconsistency in the firm’s income statement could indicate transparency issues and lead to legal trouble, which is why companies must conduct regular audits. External auditors can help to identify any current issues in financial reporting and evaluate the company’s overall financial health by performing a thorough analysis of its financial statements.
According to Lehman Brown (2014), due diligence “ordinarily incorporates investigative measures directed against all relevant matters about merger and acquisition, a series of operations including data analysis and field surveys amongst others” (p. 2). When it comes to financial due diligence, the investigation focuses on analyzing the company’s financial reporting documents to ensure that they are consistent and transparent (Lehman Brown, 2014).
Due diligence is crucial for the companies considering a merger or an acquisition, as it can help to determine any reporting or compliance issues within the target company. Due diligence can also be a means of establishing trust between the two companies considering a merger because it focuses on the transparency of financial reporting and gives a realistic portrayal of the target company’s financial performance.
In conducting due diligence, the investigators normally look for consistency in financial reporting, as well as the general financial performance of the firm. Understanding the overall financial health of the target company can help the other party to avoid investment risks, which is one of the goals behind due diligence (Lehman Brown, 2014). Common financial ratios, such as debt-to-equity, current ratio, and return on equity, and a thorough investment analysis can provide useful data on the company’s performance and highlight any financial problems experienced by the company at the moment.
Evaluating Financial Health
As discussed above, financial statements play an essential role in appraising the company’s financial health. The two main ways of using financial statements for examining business health are observing the trends in specific components of financial statements, such as accounts, liabilities, and assets, and performing ratio analysis. When used complementarily, these two methods allow gaining significant insight into the company’s financial performance and health.
First of all, observing the trends in various financial statement component provides a vision of the company’s financial performance over time. Most companies examine trends over the last 3 to 5 years, focusing on performance overall as well as individual components of the balance sheet, income statements, statements of cash flows, and statements of retained earnings (Wahlen et al., 2014).
For instance, information about the company’s accounts receivables and accounts payables can help to understand the company’s current debt and credit situation. If the value of accounts payables has grown substantially throughout the examined period, it means that the company might not be able to pay off its suppliers, which might cause supply chain management issues in the future. The consistent growth of accounts receivables, on the other hand, can result in liquidity issues, as it represents the part of the assets that cannot be used by the company unless paid by the debtors.
In addition to evaluating financial statements by components, analysts can apply financial ratios to assess the company’s financial health. Dyer, Godfrey, Jensen, and Bryce (2016) list the different types of financial ratios and describe their use depending on the goal. For instance, return on investment (ROI) ratio can be used to determine the efficiency of investment, whereas the return on retained earnings can help to evaluate if the company uses retained earnings effectively (Dyer et al., 2016). The current ratio is also widely used by businesses to assess if the company can cover its current liabilities, whereas the acid-test ratio assists in identifying major liquidity issues.
Overall, this paper showed how different stakeholders can use financial statements to examine the company’s financial health, investment opportunities, and perform due diligence. The research indicates that financial statements are a crucial tool in investigating the company’s performance and highlighting issues that could affect future growth and development. A thorough financial analysis of specific components and ratios can help to obtain a solid understanding of the firm’s current position and offer a strategic advantage when it comes to planning for the future.
Dyer, J., Godfrey, P., Jensen, R., & Bryce, D. (2016). Strategic management: Concepts and tools for creating real-world strategy. Hoboken, NJ: John Wiley & Sons.
Lehman Brown. (2014). Financial due diligence. Web.
Marchini, P. L., & D’Este, C. (2015). Comprehensive income and financial performance ratios: Which potential effects on RoE and on firm’s performance evaluation? Procedia Economics and Finance, 32(1), 1724-1739.
Nicoară, M. (2015). Balance sheet-based financial diagnosis – Working capital, working capital needs, net worth, and net treasury. Annals of the University of Oradea, Economic Science Series, 24(2), 228-236.
Wahlen, J., Baginski, S., & Bradshaw, M. (2014). Financial reporting, financial statement analysis and valuation. Scarborough, Canada: Nelson Education.