1 The need for interpretation of financial statements
Financial statements are used by a variety of users (such as investors, lenders and managers) to assist them in financial decision-making. The financial decisions of these users may be influenced by a variety of factors such as return on investment, efficiency in utilisation of resources, financial leverage, dividend pay-outs, etc. However, this information needs to be extracted and analysed to make an evaluation of a company’s earnings, its financial performance in comparison to its competitors and its ability to pay back its loans.
An evaluation of changes in the value of one item in relation to another item can help draw useful inferences about past performance as well as the estimated future performance of the company. Analysis of financial statements enables such an evaluation. Various techniques can be applied to interpret a company’s financial statements; however, it is important to be aware that these techniques, on their own, provide a limited view of corporate performance and position and should be used in conjunction with a critical evaluation of other factors, such as the accounting policies used, factors relating to corporate governance and the environment in which the company operates.
Activity 1 will encourage you to think about the factors that influence an investor’s choice of investment options.
Activity 1 Usefulness of financial statement analysis
Read the scenario and answer the question.
- Scenario
- An investor will have many options when making an investment. They may decide to invest in various asset classes such as commodities, property, shares, cryptocurrency, etc. These choices are affected by the risk profile of each asset class, the risk appetite of the investor and the capacity of the investor to absorb risks. Imagine you have £75,000 and you want to invest this money in a company’s shares.
- a.Which factors will influence your decision?
Feedback
Various factors influence an investor’s decision when making an investment. This decision is based on the risk appetite of the investor and their capacity to absorb risk. You may make an initial analysis of the environment in which the company is operating and preparing financial statements. The analysis of context entails an assessment of the key risks and opportunities and provides an indication of future business prospects. It will be followed by an assessment of the performance and position of major competitors. Finally, the investor will make an investment in an asset that matches their risk profile and generates the highest return compared to other similar investment options.
- b.How will you decide which company to invest this money in?
Feedback
You may find yourself asking such questions as: Why should I invest in one company and not another? Which company matches my risk profile and expectations regarding return?
To answer these questions, you will need to carry out an analysis of the financial statements. If you decide to invest in a company’s shares, you will have to assess the risk profile as well as the rate of return you may expect from investing in that company. Analysing the financial statements will provide you with an indication of the expected future performance and financial position of the company, and help you to compare its performance and financial position with other companies. Then you will be in a position to invest in the company which offers the best return for a given risk profile.