Published financial statements are prepared to satisfy the needs of the different users of accounts, of which investors form part. While the statements provide useful information to investors, they are not without limitations. The usefulness of using financial statements and its limitations are discussed below.
Usefulness of published financial statements
Financial statements provide information about the net worth of a business at a specific point of time and its trading performance during a given period. The value of assets owned, liabilities and capital invested are shown as well as income generated from operating activities. These are crucial information that we as investors look at first glance before going through deeper analysis.
Financial statements are the most widely available source of figures to derive ratios and other measures. Profitability, liquidity, solvency and investors ratios can be calculated. Such ratios and measures are of utmost importance, as we need to assess the return on investment (profitability), the short term financial health of the business (liquidity), the ability to deal with long term obligations and develop future assets (solvency) and earnings ratios.
The Chairman’s statement gives an overview of the performance of the organization and future plans or projects that are already in pipelines. It also gives a brief idea of how the organization intends to position itself on the market or in the industry in the future. Also, the executive report gives information about the key personnel of management, that is, by whom the business is managed. Such information enables us know who shall handle a potential investment.
Financial statements have been severely criticized for being prepared under historic cost accounting; hence change in value of assets over time is not taken into account. For example, freehold property held over years will be shown at the initial cost, while its current value may be well far above. The gains for holding such assets are not shown in the financial statements. Figures for such assets are unrealistic.
Financial statements do not take into account non monetary factors. As investors our decisions are not merely based on financial information. Such factors as training and development of employees, their motivation and mobility need to be considered as the workforce is an important stakeholder of an organization. Similarly, too little information is given on social aspects. Society tends to react adversely vis-à-vis organization with no or little ethical values. It is important to know how a potential investee positions itself in the society.
Financial statements suffer from limited data in different ways. Firstly, the two year figures provided are not enough to establish performance trends. Figures for five years for example are much more reliable for a clearer understanding of the ups and downs of the business. Secondly, financial statements provide only overall aggregate figures. Monthly detailed management accounts would be preferable for deeper analysis of the behaviour of the business month after month and depicts a clearer view of performance. Also, there is lack of comparative data, industry standards as well as competitors’ performances are not provided in financial statements for the purpose of comparisons.
The following ratios and other measures have been identified for any potential investee as well as the potential acquisitions Profitability
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