The Uses of Financial Statements

by Ben Best

(This essay presents a traditional view of financial statements. See also my essay Financial
Statements in the "New Economy").

FINANCIAL STATEMENTS: BY WHOM, FOR WHOM?

Financial statements are summaries of monetary data about an enterprise. The most common
financial statements include the balance sheet, the income statement, the statement of changes of
financial position and the statement of retained earnings. These statements are used by
management, labor, investors, creditors and government regulatory agencies, primarily. Financial
statements may be drawn up for private individuals, non-profit organizations, retailers,
wholesalers, manufacturers and service industries. The nature of the enterprise involved
dramatically affects the kind of data available in the financial statements. The purposes of the
user dramatically affects the data he or she will seek.

KINDS OF FINANCIAL STATEMENTS

The balance sheet provides the user with data about available resources as well as the claims to
those resources. The income statement provides the user with data about the profitability of the
enterprise detailing sources of revenue and the expenses which reduce profit. The statement of
changes of financial position shows the sources and uses of a firm's financial resources,
demonstrating trends in the alteration of its capital structure. The statement of retained
earnings reconciles the owners' equity section of successive balance sheets, showing what has
happened to generated revenue.

COMPARABILITY OF FINANCIAL STATEMENTS

Comparison of financial statements forms the basis for much financial analysis. Four main types
of comparison are made: (1) comparison of statements for the enterprise between successive
years (2) comparison of a firm's statements with those of a specific competitor (3) comparison of
a firm against an industry standard and (4) comparison with a target, such as a company's budget.
Comparisons between different organizations may be difficult or even meaningless because of
differences in (1) size of the organization (2) type of organization and (3) accounting methods
used by the organization. Often, both the size and type of organization will dictate the kind of
accounting methods used.

CHARACTERISTICS OF ENTITIES HAVING FINANCIAL STATEMENTS

Non-profit organizations such as government and charities typically present statements which
exhibit their resources and the way those resources are distributed or held. Stewardship and
responsibility are the focus for these statements. Financial statements for private individuals
focus on resources and obligations -- helping the person to assess his or her financial condition
and to plan financial affairs (or obtain a bank loan) [Rosenfield, 1981]. Retailers are typically
highly mortgaged, rely on credit to wholesalers (following a desire for a large and varied stock),
often offer extensive credit to customers (or no credit, on a strictly cash basis) and reside in high-
rent locations. Wholesalers tend to be characterized by large inventories, large sales volume
(with small profit margin) and chronic credit problems with retailers. Manufacturers tend to have
a substantial investment in fixed assets (machinery, equipment and buildings) and often face
major problems due to a large work-force [Costales,1979]. Service industries -- such as railroads,
airlines and public utilities -- have less of a problem with flow of inventory. Their focus tends to
be on balancing operating revenue against operating expenses dominated by fixed assets
(depreciation, repairs, replacement, maintenance, etc.). Companies with high proportions of
current assets tend to be financed through short-term borrowing and shareowner investment.
Industrial corporations tend to be financed primarily through shareowners, whereas public
utilities and railroads are more often financed by long-term borrowing (bonds) [Holmes, et
al,1970].

TYPES OF RATIO ANALYSIS

Careful financial statement analysis usually means the extraction of meaningful ratios from the
statements. These ratios have been classified as measuring (1) liquidity (current ratio, acid-test
ratio, etc.) (2) activity (receivables turnover, inventory turnover, etc.) (3) profitability (profit
margin on sales, rate of return on assets, earnings per share, etc.) and (4) leverage (debt to total
assets, times interest earned, etc.) [Kiesco and Weygandt,1982]. Ratios are often used to assess
performance or as diagnostic tools to point up potential problem areas. Given the extremely
varied entities for which financial statements are made -- and even the extreme variation between
industries of an entity type -- the most productive use of these ratios is probably made either
against industry standards or against ratios for previous years of the entity in question.

CURRENT RATIO--THE PATRIARCH RATIO

Current ratio (the ratio of current assets to current liabilities) was perhaps the earliest ratio to
gain widespread use as a measure of solvency. On the theory that $2 in current assets could
safely cover $1 of current liabilities (with enough remaining to operate) a 2-to-1 value became an
inflexible standard. But inventories can vary greatly in their liquidities. Oil, for example, can be
rapidly liquidated, but inventories of service parts could take years to sell -- hardly "current
assets". Also, small businesses can often liquidate their inventories more rapidly than large ones,
indicating that current ratio may not be comparable for different size firms. Moreover, the
relative investment in inventory rose from 77% of working capital to 83% of working capital
between 1950 and 1962 for American corporations [Miller,1966]. Just-In-Time (JIT) inventory
control using computers has dramatically decreased the amount of inventory held. Thus,
indicators from the past might not be useful for the future. A 1-to-1 "acid-test" ratio which
excluded inventory from current assets was a suggested replacement for current ratio, but the
liquidity of the receivables portion of current assets is still open to question without information
on collectability. In a strike or a recession, the business might have to pay its current liabilities
by liquidating its current assets. Yet it is questionable if this could be done without a loss in
operating capacity -- especially serious in a recession. In the case of an airline, cash flows are
more a function of its current assets than of its non-current assets.
EXAMPLES OF RATIO VARIATION BETWEEN BUSINESSES

A five-year average (1960-1964) of current ratio stands at 4.56 for hardware stores, 1.95 for
grocery stores, 4.11 for cotton cloth mills and 1.70 for building construction contractors. Note
the variation between types of retailer and manufacturer. These industry standards are not
unhealthy. Another interesting ratio is fixed assets (depreciated book value) per tangible net
worth. Five year percentages for this ratio are 5.7% for manufacturers of womens' coats, 80.1%
for manufacturers of bakery goods, 59.9% for grocery stores and 10.2% for furniture stores. In
general, this ratio is best kept low for new businesses, which should rent land and buildings until
the future of the business is ensured. Experience has shown that small businesses should attempt
not to exceed 66% and large businesses should avoid exceeding 75% [Foulke,1968].

EXAMPLE OF RATIO ANALYSIS USE

Ratios are useful to indicate various symptoms. Usually those symptoms require more detailed
analysis. For example, ratio analysis may reveal an increase in sales volume relative to inventory
and receivables. But inventories could have increased less rapidly than sales due to reduced cost
of goods, inability to replace inventory items, change in inventory policy or a change in
inventory valuation. Receivables could have increased less rapidly than sales because of a more
efficient collection policy, a larger proportion of cash sales or a change in policy with regard to
the extension of credit. Sales volume could have increased due to plant expansion, an aggressive
sales campaign, price increase, price decrease or extension of sales territories. Ratio changes lead
managers to ask pointed questions.

WHAT DIFFERENT CLASSES OF STATEMENT USERS LOOK FOR

Government officials are generally concerned that reporting and valuation regulations have been
complied with -- and that taxable income is fairly represented. Labor leaders pay particular
attention to sources of increased wages and the strength and adequacy of pension plans (which
tend to be chronically underfunded). Owners, shareholders and potential investors tend to be
most interested in profitability. Many investors look for a high payout ratio (cash dividend/net
income). Speculators pay more attention to stock value insofar as growth companies tend to have
a low payout ratio because they reinvest their earnings. Bondholders are inclined to look for
indicators of long-run solvency. Short-term creditors, such as bankers, pay special attention to
cash flow and short-term liquidity indicators, such as current ratio. Both classes of creditors
prefer lending to firms with low (usually no higher than 40-50%) leverage ratios, such as debt to
total assets.

As indicated earlier, management can use financial statements for diagnostic purposes -- with
different managers paying attention to different ratios. A buyer may look closely at inventory
turnover. Too much inventory may mean excessive storage space and spoilage, whereas too little
inventory could mean loss of sales and customers due to stock shortages. A credit manager may
be more interested in the accounts receivable turnover to assess the correctness of her credit
policies. A high sales-to-fixed-assets ratio reflects efficient use of money invested in plant and in
other productive or capital assets. Higher levels of management, as with investors, tend to look at
overall profitability ratios as the standards by which their performance is judged [Tamari,1978].
DIFFERING ACCOUNTING METHODS

Much of the incomparability of financial statements between businesses can be traced to

different accounting methods. The most striking differences occur in (1) inventory valuation
(FIFO, weighted average, etc.) (2) depreciation (straight-line, sum-of-the-years'-digits, etc.)
(3) capitalization versus expense of certain costs, eg. leases and developmentof natural
resources (4) investments in common stock carried at cost, equity, and sometimes market
(5) definition of discontinued operations and extraordinary items [Kieso and
Weygandt,1982].

EXAMPLES OF STRIKING EFFECTS OF ACCOUNTING METHODS

Superior Oil Company owned 1.4% of Texaco, Inc. which was carried at a cost of $64 million,
despite its market value of $118 million. A major brewery using LIFO inventory valuation
revealed that the average cost method would increase inventory value by $33 million [Kiesco
and Weygandt,1982]. High interest rates and a drop in oil prices caused Texaco, Inc. to reduce its
LIFO-valued inventories by 16%, netting $454 million. A loss year was thereby turned into a
profit year. General Motors doubled its net earnings in 1981 by changing its "assumed rate of
return" on its pension plan from 6% to 7% [Bernstein,1982]. With its many old and historical-
cost undervalued plants and buildings, Ford Motor Company showed historical cost earnings of
$9.75 per share in 1979, despite a current cost income of $1.78 [Greene,1980].

Patents may represent unrecorded assets insofar as their true earning value far exceeds their
costs. Goodwill is another asset with a true value which is hard to assess.

WINDOW DRESSING

If these methodological variations are not enough to make the would-be investor wary, he or she
should be aware that those who prepare financial statements often have an intention to misinform
rather than to inform. Reduction in discretionary costs (research, adverstising, maintenance,
training, etc.) can increase net income while having a detrimental effect on future earnings
potential. A new management may similarly write-down the value of assets to reduce
depreciation and amortization expenses for future years. A businessman may avoid replenishing
inventory during the period prior to closing the books so as to increase his current ratio.
Temporary payment of a current debt just prior to the financial statement date will achieve the
same result. Retained earnings can be appropriated for future inventory price decline and later
reported as net profit. Often an analysis of a series of annual statements, rather than those of a
single year, will highlight such methods. More extreme practices are generally avoided by firms
that must answer to regulatory agencies to be quoted on the stock exchange.

FOOTNOTES

There are generally two kinds of footnotes. The first type identifies and explains the major
accounting policies of the business. The second type provides additional disclosure, such as
details of long-term debts, stock option plans, details of pension plans, previous errors, lack of
internal control and law suits in progress. Although the footnotes are required, there are no
standards for clarity or conciseness. Footnotes often seem intentionally legalistic and are
awkwardly written [Tracy,1980].

EMPIRICAL STUDIES -- SOLVENCY

A survey of bank lending officers revealed that half of them would refuse to loan to a company
that did not submit financial statements, even though these might not be explicitly requested.
Bank lending officers exhibited no preference for inventory or depreciation methods, but
believed that consistency in the use of accounting methods is important [Stephens,1980].

Another study attempted to compare General Price Level (GPL) and traditional ratios in the
prediction of bankruptcy. GPL data was found to be neither more nor less accurate than historical
data. To justify the expense of preparing GPL statements, GPL data would have to be more
useful. The investigators noted that GPL data may or may not be of value for other uses of
accounting data [Norton and Smith,1979].

An extensive study was made of ratio tests in the prediction of bankruptcy. All nonliquid asset
ratios performed better than any of the liquid asset ratios -- including the highly-touted current
ratio and acid-test ratio -- for anywhere from one to five years in advance of bankruptcy. The
researcher explains that a firm with good profit prospects in a poor liquid asset position rarely
has trouble obtaining necessary funds. Another surprising discovery was that the failed firms
tended to have less rather than more inventory -- contrary to what the literature might suggest
[Beaver,1968].

EMPIRICAL STUDIES -- INVESTORS

Extensive studies were conducted of three categories of investors: individual investors,

institutional investors and financial analysts. Both individual and institutional investors regarded
long-term capital gains as more important than dividend income which was more important than
short-term capital gains. Both individual and institutional investors with portfolios under $10,000
rated short-term capital gains higher than investors with large portfolios [Most and Chang,1979].

All groups in the USA regarded financial statements as the most important source of information
for investment decisions. In the United Kingdom, only institutional investors made that
judgement. Financial analysts regarded communications with management as the most important
source, whereas individual investors preferred newspapers and magazines. Financial statements
were found to be equally important for "buy decisions" as for "hold/sell decisions" [Chang and
Most,1981].

EMPIRICAL STUDIES -- CONTROLLERS

Questionnaires were sent to controllers of the 500 largest American industrial firms with a 53.8%
response. The accountants were asked to evaluate the adequacy of current reporting procedures.
The disclosure rated as more deficient, accounting for human resources, was ranked fifth in
importance. Effects of price-level changes were deemed the second largest deficiency, but
ranked sixth in importance. The rate of return on investment was rated third in deficiency, but
first in importance [Francia and Strawser,1972].

QUALIFICATION ON THE USEFULNESS OF FINANCIAL STATEMENTS

Although financial statements provide information useful to decision-makers, there is much

relevant information that they omit. Factors of market demand, technological developments,
union activity, price of raw materials, human capital, tariffs, government regulation, subsidies,
competitor actions, wars, acts of nature, etc. can have a dramatic effect on a company's
prospects.

CONCLUSION

A critical assumption in the use of financial statements (aside from stewardship), is often made
that the past will predict the future. For trends that have continued for many years this will
usually be true, at least for the near future. Ratio analysis for a single company or within an
industry using similar accounting methods will be the most fruitful way of using the data
provided by financial statements.

(See also my essay Financial Statements in the "New Economy").

REFERENCES

• Beaver, William H. "Alternative Accounting Measures as Predictors of Failure"

Accounting Review (January 1968), p.113-22
• Bernstein, Aaron, "Reading Between the Lines," Forbes (May 10, 1982), p.78
• Chang, Lucia S. and Most, Kenneth S., "An International Comparison of Investor Uses of
Financial Statements," The International Journal of Accounting Education and
Research (Fall 1981)
• Costales, S. B., The Guide to Understanding Financial Statements (McGraw-Hill
Book Company, 1979)
• Francia, Arthur J. and Strawser, Robert H., "Attitudes of Management Accountants on
the State of the Art," Management Accounting (May 1972), p.21-24
• Foulke, Roy A., Practical Financial Statement Analysis (McGraw-Hill Book
Company, 1968)
• Greene, R., "Living off Capital", Forbes (May 10, 1982), p.78
• Holmes, Arthur W. et al, Accounting for Control and Decisions (Business Publications,
1970)
• Kieso, Donald W. and Weygandt, Jerry J., Intermediate Accounting: Canadian
Edition (John Wiley & Sons Canada Limited, 1982)
• Most, Kenneth S. and Chang, Lucia S., "How Useful are Annual Reports to Investors?"
The Journal of Accountancy (September 1979), p.111-113
• Norton, Curtis L. and Smith, Ralph E., "A Comparison of General Price Level and
Historical Cost Financial Statements in the Prediction of Bankruptcy" The Accounting
Review (January 1968), p.113-2
• Rosenfield, Paul, "Persoanl and Business Financial Statements: How their Objectives
Differ", The Journal of Accountancy (July 1981), p.94, 96-8
• Stephens, Ray G., Uses of Financial Information in Bank Lending Decisions (UMI
Research Press, 1980)
• Tamari, M. Financial Ratios: Analysis and Prediction (Paul Elek Ltd., 1978)
• Tracy, John A. How to Read a Financial Report (John Wiley & Sons, Inc. 1980)