Question One
Financial statements can be viewed from three perspectives; shareholders, creditors and managers. To begin with, a company’s management is the largest users of its financial statements. It primarily relies on financial statements such as the statement of financial position, statement of income and cash flow statements to determine the effectiveness of all decisions it makes in the course of running the company. The owners of any company elect managers and directors to manage all the funds they invest into the company. As a result, the management is fully answerable to the shareholders and must deliver periodic reports detailing the effectiveness of all the actions they take in the course of managing the business. Furthermore, financial statements provide the largest avenue through which the management of any company communicates with external quarters about the performance of the company. Second, shareholders rely upon financial statements to assess the contribution of the company in increasing their wealth (Moles, Parrina & Kidwell 2011, p. 114). It is noteworthy that money is hardly earned and shareholders take all appropriate measures to monitor the manner in which managers of their funds use such funds to increase their wealth. Finally, long-term and short-term creditors rely upon financial statements to assess the ability and likelihood of the borrowing company to repay all loans extended to them within the agreed time and under stipulated terms. In summary, stakeholders rely upon a company’s financial statements to decide whether they would engage the company in any business.
Question Two
There are differences in the manner in which shareholders and creditors of a company use all financial statements issued by the company. Despite both parties providing funds to a company, it is important to note that creditors do not own the company as opposed to shareholders who own the company. Also, shareholders gain from a company through share gains and dividends while creditors anticipate interests on the amounts they lend to the company. Shareholders require financial statements to assess the value of the company into which they intend to invest their funds. Also, shareholders are paid differential dividends depending on the amount of profits generated by a company during a specific year while creditors expect to be paid interest on their funds irrespective of the amount of profits generated by the company. They must invest only in companies which promise highest return on invested funds. Creditors are primarily concerned with the company’s liquidity ratios while shareholders are mostly concerned with the profitability of the company.
Question Three
The users of financial ratios can benchmark such ratios against those of competing companies, industry or past trends. Time-trend analysis implies a comparison of a company’s current financial ratios against the ratios attained by the same company over the past years. A trend analysis can be conducted for a minimum of three years. This method can be adopted provided the company does not change its line of business, and would be irrelevant if the company changed its core business. A change in a company’s core business changes the market it serves. This method measures the increase or decrease in the effectiveness of decisions made by the management of the company. Users can also benchmark its ratios against the industry average. Industry average refers to the simple mean of all the ratios attained by all companies serving the industry in which the main company operates. It puts the company in a spotlight of its industry it serves. Finally, financial ratios can be benchmarked against those of the company’s competitors. The selected peer must be operating in the same industry, must be of same size as the main company and must be in the business of providing substitute products. It analyses the effectiveness of the company’s marketing strategies, and quality of products it offers to its customers.
Question Four
Despite offering a simple way of analysing the performance of a company, ratio analysis is riddled with some limitations. To begin with, ratio analysis depends on historical data. There is no guarantee that historical data will have relevance to future data. Second, there is no theoretical basis of making judgements as to which level of financial ratio is the best. Third, ratio analysis does not fit into any one ISIC code. Fourth, the fact that different companies use different basis to prepare their financial statements further complicates the process of comparing their financial statements. For example, company could be using LIFO in valuing its inventory while company B uses FIFO, a fact which complicates the process of comparing the performance of the two companies.
References
Damodaran, A (2010). Applied Corporate Finance (3rd edn). New York: John Wiley & Sons
Moles, P., Parrino, R. & Kidwell, D. S. (2011). Corporate Finance. New York: John Wiley & Sons
