Uses and Importance of Financial Statements

The financial statements of a company are not prepared for their own sake. They serve a wide range of users — management, investors, shareholders, creditors, the government, bankers, employees, and the public. Each group looks at the statements for a different purpose, but the common thread is that financial statements help them assess the company’s performance and make informed economic decisions.

It is important to remember that the financial statements are just one part of a company’s annual report. The annual report also includes the directors’ report, auditors’ report, corporate governance report, and management discussion and analysis. The financial statements form the core numerical data, but the other reports provide context and explanation.

The textbook lists seven specific uses and points of importance. Each one is explained below.

1. Report on stewardship function

The management of a company is entrusted with the shareholders’ money. The shareholders are the owners, but they do not run the day-to-day operations. Financial statements act as a report card. They show how well the management has performed its duty — its stewardship — in using the company’s resources. By comparing actual performance with what the owners expected, shareholders can judge whether the management has acted in their best interest.

2. Basis for fiscal policies

The government uses the financial performance of corporate undertakings to design its fiscal policies, especially taxation. For example, the rate of corporate tax, the rules for depreciation, and the treatment of certain expenses are all linked to how companies report their profits. Financial statements provide the basic input for the government’s industrial, taxation, and other economic policies.

3. Basis for granting of credit

Companies often need to borrow money from banks and financial institutions. Before lending, these institutions study the financial statements to judge the company’s ability to repay. They look at profitability, liquidity, and solvency. A company with strong financial statements is more likely to get credit on favourable terms. Thus, financial statements form the basis for credit decisions.

4. Basis for prospective investors

Investors — both short-term and long-term — want to know three things before putting their money in a company: security of their investment, liquidity (how easily they can get their money back), and reasonable profitability. Financial statements help them assess the company’s long-term and short-term solvency as well as its profitability. Without these statements, an investor would be making a blind decision.

5. Guide to the value of the investment already made

Existing shareholders are not just interested in the past. They want to know the current status of their investment, its safety, and the return they are earning. They may also need to decide whether to hold on to their shares or sell them. Financial statements provide the information needed to make such decisions about continuing or discontinuing an investment.

6. Aids trade associations in helping their members …