Analysis and use of financial statements
Financial Statements are important for any organization to judge and evaluate its financial stability and future prospects. These financial statements give the investors insights about the performance of the company which assists them in making important decisions about the investments. But these statements sometimes can be misleading and manipulative. It might sometimes show some financial growths which actually might not be taking place. There are various techniques of manipulation of these statements without actual growth in the earnings of the company. Hence the manager must be careful while using these statements for proposing any important investments for the company.
Financial statements show the financial records of the company for a particular operating cycle. There are many components of this statement that are important for the successful running of the business. These include suppliers also. Suppliers are those entities who provide raw materials and semi-finished goods to the company for further manufacturing and value addition processes. Hence managing these suppliers is important for any organization. In this regard selection and evaluation of the financial statement of the suppliers gives important insights into their stability and growth potential. This analysis would help organizations to mitigate the risk associated with the selection of efficient suppliers. Hence some of the important strengths of financial statements are:
It might be always easy to read and understand these statements due to incoherent structure and poor formats. Manipulations of the components of these financial statements often make it difficult for the users to make correct decisions. Sometimes these financial statements might not provide important insights into the financial health of the company wherein the reported assets and liabilities are not clear.
There are many different types of accessors to financial statements. So it is based objective of the user for which these statements are used. Thus it may provide information on varied fronts. For example, the investors might be interested in knowing the creditworthiness and the financial stability & growth prospects of the organization. Hence they use different ratios for this purpose and evaluate information from these statements.
Similarly, the employees of the organization might be evaluating these statements with some other interests. They might be looking forward to stability in order to bargain effectively with the management. Customers might be using these statements to understand the effectiveness of the working of these companies to analyze the justification of the prices charged for the goods.
The important limitations of financial statements include:
To determine the supplier’s ability to remain in business and avoid cash flow problems, we would look into the following:
The given below is the financial parameters that help judge the company’s ability to attract financial capital:
| Parameter | Formula | Implication |
| EPS(Earning per share) | Total earnings/total share | This shows the earnings made for each share issued by the company. |
| Dividend Cover | EPS/ dividend per share | This shows the effectiveness of the company to provide dividends to the investors |
| Dividend Yield | Dividend/market price | This shows the dividend given in respect of the market price of the share. |
| P/E Ratio | Market price/ Diluted EPS | This shows the performance of the business |
| Payout Ratio | Dividend /total earnings | This shows the dividend provided in respect of earnings. |
These parameters are used by the investors to determine the attractiveness of the company towards new capital.
| Proposals | Net Income | Net Cash Flows from Operating Activities | Cash |
| First | Increase | No Change | No Change |
| Second | Increase | No Change | No Change |
| Third | Increase | Increase | Increase |
| Fourth | No Change | Increase | Increase |
| Fifth | Increase | Increase | Increase |
| Sixth | No Change | No Change | Increase |
Here we explain each proposal in detail to understand the reason behind each answer in part a.
Proposal 1- Switching from LIFO to FIFO method of inventory valuation.
This proposal of change in the inventory valuation method would help to reduce the cost of goods sold. This will have an effect on the net income as the net income would increase. But as there is no cash transaction done here, there will not be any change in Cash or Cash Flows.
Proposal 2- Switching from declining balance method to straight-line method of depreciation.
This switch of the depreciation method will help to increase the reported net income as the depreciation reported would reduce. But as there has been no cash transaction, there will be no effect on the Cash or Cash Flows.
Proposal 3- Increasing Sales through inventory increase of Dealers.
This method to be adopted by the company would help to increase sales this year’s sales by piling up inventory at the dealer’s place. But in the subsequent years, this sale volume will decrease due to inventory already piling up at dealers end. However, this will help show an increase in net profit this year. Also as there is cash transaction taking place, this will lead to an increase in Cash Flow and Cash balances.
Proposal 4- Reducing the payment period of dealers.
Opting for this proposal would help the company in realizing the payments earlier from the dealers. This will not create any impact on the net income of the company as the amount of goods sold remains the same. But as the cash is received early, there will be a short term increase in the cash flows.
Proposal 5- Borrowing at short term interest rates.
If the company opt for this proposal and borrow at the short term interest rate of 10% to pay off the long term debt which has been taken at a 13% rate of interest, the net income of the company would increase. This will be due to the reduction in the interest charges. As this transaction involves cash, there will also be an increase in the Cash Flow and cash balance.
Proposal 6- Substituting stock dividend for a Cash dividend.
This proposal of opting for the stock dividend to pay off the investors instead of paying the cash dividends would leave no effect on the net income of the organization. But this would have an effect on the Cash Flow and Cash balance of the company. The cash balance of the company would increase for the short term.
Based on the happenings at Flexcom Inc, we need to bother about the following observations:
Observation 1 – There has been a steady increase in net income over the last three years despite sluggish sales. In the accounting concepts, sales and net income are related. When the sale of the company increases, the net income reported also increases. But here, despite the declining sales, the net income is increasing. This might be due to the reasons such as improvement in technology, reduction in the cost of raw materials, etc. But in this regard, further investigation needs to be done to find out if there has been any manipulation in the books of account of this company to show higher earnings.
Observation 2- An increase in the inventory at a higher than normal rate is important for any organization to manage inventory most effectively as inventory pile-up would mean the inventory is obsolete especially in the technology domain. In these type of companies which is based on technology, the replenishment of inventory is very important to keep the company updated in the stock of new technology. The profitability of the organization is also dependent on the inventory turnover. Thus organizations should take care to reduce obsolete inventory.
Observation 3 – allowance for reduction of obsolete inventory has declined over the years. Organizations should undergo inventory evaluation from time to time for proper valuation of inventory in the financial statements of the company. As the allowance for obsolete inventory has reduced, the reported net income must have increased. This is because of the higher value for inventory reported in the financial statement. But this inventory should be investigated carefully, to understand if any manipulation has been done to enhance the profitability. Obsolete inventory for a technology-driven company would mean losses for the organization.
This analysis shows us the importance of financial statements in the working and decision making of the organization. Here we see how these are used in real-life situations by the managers and experts. Finance is the backbone of any business and the reports showing these are of vital importance. But as stated above, the managers and decision-makers need to be vigilant about the manipulations and misinterpretations which might arise in these statements. Thus these statements must be used with utmost care and prudence.
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