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FINANCIAL STATEMENTS: BY WHOM, FOR WHOM?

Financial statements are summaries of monetary data about an enterprise. The most common
financial statements include the balance sheet, the income statement, the statement of changes
of financial position and the statement of retained earnings. These statements are used by
management, labor, investors, creditors and government regulatory agencies, primarily.
Financial statements may be drawn up for private individuals, non-profit organizations,
retailers, wholesalers, manufacturers and service industries. The nature of the enterprise
involved dramatically affects the kind of data available in the financial statements. The
purposes of the user dramatically affects the data he or she will seek.
KINDS OF FINANCIAL STATEMENTS
The balance sheet provides the user with data about available resources as well as the claims
to those resources. The income statement provides the user with data about the profitability
of the enterprise detailing sources of revenue and the expenses which reduce profit.
The statement of changes of financial position shows the sources and uses of a firm's
financial resources, demonstrating trends in the alteration of its capital structure.
The statement of retained earnings reconciles the owners' equity section of successive
balance sheets, showing what has happened to generated revenue.
COMPARABILITY OF FINANCIAL STATEMENTS
Comparison of financial statements forms the basis for much financial analysis. Four main
types of comparison are made: (1) comparison of statements for the enterprise between
successive years (2) comparison of a firm's statements with those of a specific competitor
(3) comparison of a firm against an industry standard and (4) comparison with a target, such
as a company's budget. Comparisons between different organizations may be difficult or even
meaningless because of differences in (1) size of the organization (2) type of organization and
(3) accounting methods used by the organization. Often, both the size and type of
organization will dictate the kind of accounting methods used.
CHARACTERISTICS OF ENTITIES HAVING FINANCIAL STATEMENTS
Non-profit organizations such as government and charities typically present statements which
exhibit their resources and the way those resources are distributed or held. Stewardship and
responsibility are the focus for these statements. Financial statements for private individuals
focus on resources and obligations -- helping the person to assess his or her financial
condition and to plan financial affairs (or obtain a bank loan) [Rosenfield, 1981]. Retailers
are typically highly mortgaged, rely on credit to wholesalers (following a desire for a large
and varied stock), often offer extensive credit to customers (or no credit, on a strictly cash
basis) and reside in high-rent locations. Wholesalers tend to be characterized by large
inventories, large sales volume (with small profit margin) and chronic credit problems with
retailers. Manufacturers tend to have a substantial investment in fixed assets (machinery,
equipment and buildings) and often face major problems due to a large work-force
[Costales,1979]. Service industries -- such as railroads, airlines and public utilities -- have
less of a problem with flow of inventory. Their focus tends to be on balancing operating
revenue against operating expenses dominated by fixed assets (depreciation, repairs,
replacement, maintenance, etc.). Companies with high proportions of current assets tend to be
financed through short-term borrowing and shareowner investment. Industrial corporations
tend to be financed primarily through shareowners, whereas public utilities and railroads are
more often financed by long-term borrowing (bonds) [Holmes, et al,1970].
TYPES OF RATIO ANALYSIS
Careful financial statement analysis usually means the extraction of meaningful ratios from
the statements. These ratios have been classified as measuring (1) liquidity (current ratio,
acid-test ratio, etc.) (2) activity(receivables turnover, inventory turnover, etc.)
(3) profitability (profit margin on sales, rate of return on assets, earnings per share, etc.) and
(4) leverage (debt to total assets, times interest earned, etc.) [Kiesco and Weygandt,1982].
Ratios are often used to assess performance or as diagnostic tools to point up potential
problem areas. Given the extremely varied entities for which financial statements are made --
and even the extreme variation between industries of an entity type -- the most productive use
of these ratios is probably made either against industry standards or against ratios for
previous years of the entity in question.
CURRENT RATIO--THE PATRIARCH RATIO
Current ratio (the ratio of current assets to current liabilities) was perhaps the earliest ratio to
gain widespread use as a measure of solvency. On the theory that $2 in current assets could
safely cover $1 of current liabilities (with enough remaining to operate) a 2-to-1 value
became an inflexible standard. But inventories can vary greatly in their liquidities. Oil, for
example, can be rapidly liquidated, but inventories of service parts could take years to sell --
hardly "current assets". Also, small businesses can often liquidate their inventories more
rapidly than large ones, indicating that current ratio may not be comparable for different size
firms. Moreover, the relative investment in inventory rose from 77% of working capital to
83% of working capital between 1950 and 1962 for American corporations [Miller,1966].
Just-In-Time (JIT) inventory control using computers has dramatically decreased the amount
of inventory held. Thus, indicators from the past might not be useful for the future. A 1-to-1
"acid-test" ratio which excluded inventory from current assets was a suggested replacement
for current ratio, but the liquidity of the receivables portion of current assets is still open to
question without information on collectability. In a strike or a recession, the business might
have to pay its current liabilities by liquidating its current assets. Yet it is questionable if this
could be done without a loss in operating capacity -- especially serious in a recession. In the
case of an airline, cash flows are more a function of its current assets than of its non-current
assets.
EXAMPLES OF RATIO VARIATION BETWEEN BUSINESSES
A five-year average (1960-1964) of current ratio stands at 4.56 for hardware stores, 1.95 for
grocery stores, 4.11 for cotton cloth mills and 1.70 for building construction contractors. Note
the variation between types of retailer and manufacturer. These industry standards are not
unhealthy. Another interesting ratio is fixed assets (depreciated book value) per tangible net
worth. Five year percentages for this ratio are 5.7% for manufacturers of womens' coats,
80.1% for manufacturers of bakery goods, 59.9% for grocery stores and 10.2% for furniture
stores. In general, this ratio is best kept low for new businesses, which should rent land and
buildings until the future of the business is ensured. Experience has shown that small
businesses should attempt not to exceed 66% and large businesses should avoid exceeding
75% [Foulke,1968].
EXAMPLE OF RATIO ANALYSIS USE
Ratios are useful to indicate various symptoms. Usually those symptoms require more
detailed analysis. For example, ratio analysis may reveal an increase in sales volume relative
to inventory and receivables. But inventories could have increased less rapidly than sales due
to reduced cost of goods, inability to replace inventory items, change in inventory policy or a
change in inventory valuation. Receivables could have increased less rapidly than sales
because of a more efficient collection policy, a larger proportion of cash sales or a change in
policy with regard to the extension of credit. Sales volume could have increased due to plant
expansion, an aggressive sales campaign, price increase, price decrease or extension of sales
territories. Ratio changes lead managers to ask pointed questions.
WHAT DIFFERENT CLASSES OF STATEMENT USERS LOOK FOR
Government officials are generally concerned that reporting and valuation regulations have
been complied with -- and that taxable income is fairly represented. Labor leaders pay
particular attention to sources of increased wages and the strength and adequacy of pension
plans (which tend to be chronically underfunded). Owners, shareholders and potential
investors tend to be most interested in profitability. Many investors look for a high payout
ratio (cash dividend/net income). Speculators pay more attention to stock value insofar as
growth companies tend to have a low payout ratio because they reinvest their earnings.
Bondholders are inclined to look for indicators of long-run solvency. Short-term creditors,
such as bankers, pay special attention to cash flow and short-term liquidity indicators, such as
current ratio. Both classes of creditors prefer lending to firms with low (usually no higher
than 40-50%) leverage ratios, such as debt to total assets.
As indicated earlier, management can use financial statements for diagnostic purposes -- with
different managers paying attention to different ratios. A buyer may look closely at inventory
turnover. Too much inventory may mean excessive storage space and spoilage, whereas too
little inventory could mean loss of sales and customers due to stock shortages. A credit
manager may be more interested in the accounts receivable turnover to assess the correctness
of her credit policies. A high sales-to-fixed-assets ratio reflects efficient use of money
invested in plant and in other productive or capital assets. Higher levels of management, as
with investors, tend to look at overall profitability ratios as the standards by which their
performance is judged [Tamari,1978].
DIFFERING ACCOUNTING METHODS
Much of the incomparability of financial statements between businesses can be traced to
different accounting methods. The most striking differences occur in (1) inventory
valuation (FIFO, weighted average, etc.) (2) depreciation (straight-line, sum-of-the-years'-
digits, etc.) (3) capitalization versus expense of certain costs, eg. leases and developmentof
natural resources (4) investments in common stock carried at cost, equity, and sometimes
market (5) definition of discontinued operations and extraordinary items [Kieso and
Weygandt,1982].
EXAMPLES OF STRIKING EFFECTS OF ACCOUNTING METHODS
Superior Oil Company owned 1.4% of Texaco, Inc. which was carried at a cost of $64
million, despite its market value of $118 million. A major brewery using LIFO inventory
valuation revealed that the average cost method would increase inventory value by $33
million [Kiesco and Weygandt,1982]. High interest rates and a drop in oil prices caused
Texaco, Inc. to reduce its LIFO-valued inventories by 16%, netting $454 million. A loss year
was thereby turned into a profit year. General Motors doubled its net earnings in 1981 by
changing its "assumed rate of return" on its pension plan from 6% to 7% [Bernstein,1982].
With its many old and historical-cost undervalued plants and buildings, Ford Motor Company
showed historical cost earnings of $9.75 per share in 1979, despite a current cost income of
$1.78 [Greene,1980].
Patents may represent unrecorded assets insofar as their true earning value far exceeds their
costs. Goodwill is another asset with a true value which is hard to assess.
WINDOW DRESSING
If these methodological variations are not enough to make the would-be investor wary, he or
she should be aware that those who prepare financial statements often have an intention to
misinform rather than to inform. Reduction in discretionary costs (research, adverstising,
maintenance, training, etc.) can increase net income while having a detrimental effect on
future earnings potential. A new management may similarly write-down the value of assets to
reduce depreciation and amortization expenses for future years. A businessman may avoid
replenishing inventory during the period prior to closing the books so as to increase his
current ratio. Temporary payment of a current debt just prior to the financial statement date
will achieve the same result. Retained earnings can be appropriated for future inventory price
decline and later reported as net profit. Often an analysis of a series of annual statements,
rather than those of a single year, will highlight such methods. More extreme practices are
generally avoided by firms that must answer to regulatory agencies to be quoted on the stock
exchange.
FOOTNOTES
There are generally two kinds of footnotes. The first type identifies and explains the major
accounting policies of the business. The second type provides additional disclosure, such as
details of long-term debts, stock option plans, details of pension plans, previous errors, lack
of internal control and law suits in progress. Although the footnotes are required, there are no
standards for clarity or conciseness. Footnotes often seem intentionally legalistic and are
awkwardly written [Tracy,1980].
EMPIRICAL STUDIES -- SOLVENCY
A survey of bank lending officers revealed that half of them would refuse to loan to a
company that did not submit financial statements, even though these might not be explicitly
requested. Bank lending officers exhibited no preference for inventory or depreciation
methods, but believed that consistency in the use of accounting methods is important
[Stephens,1980].
Another study attempted to compare General Price Level (GPL) and traditional ratios in the
prediction of bankruptcy. GPL data was found to be neither more nor less accurate than
historical data. To justify the expense of preparing GPL statements, GPL data would have to
be more useful. The investigators noted that GPL data may or may not be of value for other
uses of accounting data [Norton and Smith,1979].
An extensive study was made of ratio tests in the prediction of bankruptcy. All nonliquid
asset ratios performed better than any of the liquid asset ratios -- including the highly-touted
current ratio and acid-test ratio -- for anywhere from one to five years in advance of
bankruptcy. The researcher explains that a firm with good profit prospects in a poor liquid
asset position rarely has trouble obtaining necessary funds. Another surprising discovery was
that the failed firms tended to have less rather than more inventory -- contrary to what the
literature might suggest [Beaver,1968].
EMPIRICAL STUDIES -- INVESTORS
Extensive studies were conducted of three categories of investors: individual investors,
institutional investors and financial analysts. Both individual and institutional investors
regarded long-term capital gains as more important than dividend income which was more
important than short-term capital gains. Both individual and institutional investors with
portfolios under $10,000 rated short-term capital gains higher than investors with large
portfolios [Most and Chang,1979].
All groups in the USA regarded financial statements as the most important source of
information for investment decisions. In the United Kingdom, only institutional investors
made that judgement. Financial analysts regarded communications with management as the
most important source, whereas individual investors preferred newspapers and magazines.
Financial statements were found to be equally important for "buy decisions" as for "hold/sell
decisions" [Chang and Most,1981].
EMPIRICAL STUDIES -- CONTROLLERS
Questionnaires were sent to controllers of the 500 largest American industrial firms with a
53.8% response. The accountants were asked to evaluate the adequacy of current reporting
procedures. The disclosure rated as more deficient, accounting for human resources, was
ranked fifth in importance. Effects of price-level changes were deemed the second largest
deficiency, but ranked sixth in importance. The rate of return on investment was rated third in
deficiency, but first in importance [Francia and Strawser,1972].
QUALIFICATION ON THE USEFULNESS OF FINANCIAL STATEMENTS
Although financial statements provide information useful to decision-makers, there is much
relevant information that they omit. Factors of market demand, technological developments,
union activity, price of raw materials, human capital, tariffs, government regulation,
subsidies, competitor actions, wars, acts of nature, etc. can have a dramatic effect on a
company's prospects.
CONCLUSION
A critical assumption in the use of financial statements (aside from stewardship), is often
made that the past will predict the future. For trends that have continued for many years this
will usually be true, at least for the near future. Ratio analysis for a single company or within
an industry using similar accounting methods will be the most fruitful way of using the data
provided by financial statements.