The following paper will introduce the uses and benefits of financial statements. In doing so the paper will first introduce the different elements of a financial statement. In a next step the paper will establish how financial statements can be used in financial modeling and how the useful basis for an encompassing analysis. The paper will conclude with the observation that a financial statement provides a transparent insight into the economic positioning of an organization that allows investors and managers alike to act economically efficient.
Contents
Elements of a Financial Statement
Financial Statement Modeling
Company Valuation
Asset based approach
Income based approach
Market based approach
Project evaluation
Conclusion
References
Uses and Benefits of Financial Statements
The following paper will introduce the uses and benefits of financial statements. In doing so the paper will first introduce the different elements of a financial statement. In a next step the paper will establish how financial statements can be used in financial modeling and how the useful basis for an encompassing analysis. The paper will conclude with the observation that a financial statement provides a transparent insight into the economic positioning of an organization that allows investors and managers alike to act economically efficient.
Elements of a Financial Statement
There are different financial statements that can be provided. Often these different statements are combined and thus provide a comprehensive dataset for further analysis. Therefore, different financial statements hold different implications for a financial analysis. Essentially, a financial statement can be divided in eight different elements. Each category offers different information and is thus of different use for an analysis. They are characterized and presented here.
The income statement is a public statement that reports a company's profitability in a set timeframe (Investopedia, 2017-I). The profitability is measured by the performance. The income statement gives a summary on the means and the amount of revenues and expenses through operating and non-operating activities, and net profit. The past performance indicates the profitability of an investment and is therefore useful for financial analysis (Sare et al., 2013).
The Balance Sheet summarizes a company's assets, liabilities and shareholders' equity (Investopedia, 2017-II). It gives indications for the overall utilization of assets. Different ratios like the total turnover asset ratio can be used to measures the rate of efficiency of a firm with regards of the uses its assets. These efficiencies are of interest for a financial analysis.
The Cash Flow statement demonstrates “the net amount of cash and cash-equivalents moving into and out of a business” (Investopedia, 2017-III). This statement offers information in regards to a company's income and its liquidity. A positive cash flow indicates solvency. The ability to cover short term obligations is a vital part of any financial analysis.
The Segment Revenue and Operating Income (Loss) Statement gives an overview of the different segments the company generates profit in and the respective operating income in this segments. Operating income “measures the amount of profit realized from a business's operations, after deducting operating expenses such as cost of goods sold (COGS), wages and depreciation” (Investopedia, 2017-IV). The statement list also unallocated revenue.
The Historical income statement gives an overview of the income statements over the past years. The Financial Operating Segment History is similar to the Segment Revenue and Operating Income (Loss) Statement, but offers a quarterly breakdown. The Yearly Income Statement contextualizes the Income Statements a sequence of years. The Unearned Revenue statement demonstrates the “money received by an individual or company for a service or product that has yet to be fulfilled” (Investopedia, 2017-V).
The use of a financial statement or any combination of these statements offers a comprehensive basis for financial analysis.
Financial Statement Modeling
Using these financial statements an analysist is able to create a financial model. Financial models are a statistical representation of the financial situation of an organization. Through the different mathematical models, so called ratios, further information can be derived from the data sets provided by the model. This in turn offers more transparency in the financial situation of the organization.
Therefore, different aspect has to be taken into consideration when creating such models. Firstly, the goal of the financial analysis has to be identified. Financial models take into account different data or present data differently than valuation models (Simpson, 2016). Thus, the model accordingly has to be build accordingly. Secondly, the audience of the financial model has to be taken into account. The results of an analysis within a presentation, it should be – if possible – self-explanatory. If a presentation is published in a business environment and is not self-explanatory, it often leads to miscommunication and in the worst case to miscalculations and botched planning. Thirdly, the cost-benefit-balance of any financial model has to be considered. Simplified this means: The complexity of a financial model has to correspond with the goal and the audience. Based upon this complexity the subsequent data sets and respective financial statements have to be utilized (Atkinson, 1999). In creating the model, it is essential to identify the sufficient data to foster the initially identified goal. A financial model quantifies variables of a given event and build formulas and models around these variables (Investopedia, 2017-VI). Commonly, the following factors have to be taken into consideration:
- Macro-economic market perspective: To ensure a precise description of the existing or expected environments the market can be analyzed through four variables: Sociological, technological, economic and political/legal. This could, for example, be achieved through the framework of the STEP analysis.
- Micro-economic market perspective: Approaches like Porter’s Five Forces are a micro-economic approach that analyses a given market in regards to barrier, competitors and similar.
- Company perspective: profitability, investments, requirements
- Project perspective: time, money, man-hours/man-days,
- Individual perspective: cost, effort, benefit
This illustrates that different perspectives of financial models make different data sets necessary. A historical income statement pared with a micro-economic market perspective can, for example, illustrate the income development over the past years in direct comparison to the development in respective industry and the competitor average. A manger might be able to adjust cash flow management and operational spending to be more competitive by using this data. An investor could identify the positioning of an organization and thus the potential of an investment.
To illustrate the benefits of financial statements, the paper will now illustrate the two essential uses of financial statements in financial modeling.
Company Valuation
The valuation of a company is the process of identifying the present value of a company. It can be approached in different ways. Commonly, these approaches can be classified in three categories:
Asset based approach
Asset based approaches focus on the book value of a company. This implies the value of the asset’s net of liabilities. The book value is the value that an asset is capitalized at or that an asset capitalized as a capital item by balance sheet data (Investopedia, 2017-VII). Essentially, the carrying amount of a company is the value of the equity capital attributable to the company owner. Therefore, all assets are reduced by liabilities and affected by decisions on depreciation and similar variables. The asset based approach is widely considered less beneficial in regards to intangible assets. Their historical production costs (or their replacement costs) only weakly correlate with the future use of intangible assets. This is a direct result of the high profit risk.
For this approach, the balance sheet, cash flow statement and historical financial statements are vital.
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- Jan Alexander Linxweiler (Autor), 2017, Uses and Benefits of Financial Statements, Múnich, GRIN Verlag, https://www.grin.com/document/371138
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