Financial Statements - Performance Indicator Of An Entity:

Financial statements are useful for analyzing an entity' financial position and performance by the users such as the owners and investors, management, suppliers, lenders, employees, customers, the government, and the general public. In accounting perspective, the term "Financial Statement" fundamentally refers to four core statements -

1. The Balance Sheet:

It is primarily helpful to figure out two main points of an entity on a given date.

The Assets versus Liabilities (what is the value of the company? Who owns what?)

a. Current Ratio:

It considers the liquidity perspective of the balance sheet. Can the company meet its obligations in the next financial period? In order to evaluate this, it is necessary to figure the current ratio (a measure of working capital). It compares the current assets of the entity, assets that can be turned into cash in the next year, with current liabilities, which are obligations that have to be met in the next accounting year.

b. Owners Equity:

It basically reflects changes in the owner's equity in the given period of time. It shows the opening balance of owner's equity, plus contributions if any made thereafter, plus reinvested amount of profit (if any) minus owner's withdrawal (if any).

2. Income Statement:

Although it reflects the profit or loss of an entity by segregating the direct and indirect incomes and expenses on a given date, but here for the purpose of assessment, the primary question is the earnings growth and growth of net income on the income statement.

Here, the question is, Is it earning? - If yes, what is its earnings growth compared to sales growth? The income statement will reflect if the sales growth rate is going up and so is the net earnings growth rate. If they are not, then the company might have earnings going up and the revenue is coming down.

3. Profitability (The Return On Assets):

Return on assets is an indicator of how profitable a company is relative to its total assets. Return on assets gives an idea of how efficient management is at using its assets to generate earnings.

The best measure of a entity is its profitability, without it, an entity cannot grow, and if it doesn't have the required growth, then its stock will reflect a downward trend which will not be a healthy sign. Increase in profits indicates that a company can pay dividends and that the share price will trend upward. Creditors will extend loan at a cheaper rate, compared to unprofitable entity; and eventually, the stockholders' equity of profitable entity will rise even more.

The common profitability measures compare profits with sales, assets, or equity: net profit margin, return on assets, and return on equity.

4. Cash Flow Statement:

It is something that all wise interested parties (internal or external) look for all of the time. It caters to questions like- Is this company bringing in real cash? Is the company generating cash by selling off stock, or borrowing money, or selling part of business? How is it getting the money?

The cash flow statement reflects the categorized inflow and outflow of cash. Inflows like sales, interest income and loan proceeds and outflows like staff salaries, loan payments, taxes and fixed assets and current purchased during the period.

Putting it all together, we get the financial statements which are a quantitative way for assessment of an entity's performance based on the following metrics:

Reports on Financial Statements:

These key financial metrics form the financial statements, to figure out how good a company really is and if this company is something wherein safe investment can be made in the future. Financial Statements need to be such presented, that a fast and precise analysis of the financial health of the entity can be performed.

The primary area of focus is to properly analyse Gross Profit (Cost of goods sold) against the operating expenses and the Gross Margin that amplifies the entity. Low gross margin percentage voluminous sales of low quality items at low price whereas high gross margin percentage reflects that the business entity is focused on both quality product with great services and highly priced.

Higher gross margin percentage reflects that the entity is interested in the higher net profit, which indicates that the business will have the ability to repay the loan. Non- recurring contingencies also needs to be considered and should be excluded from the preview of calculation.

Bankers Point Of View :

Form the point of view of the bankers, banks are mostly focused on the liquidity of the entity, they prefer higher the amount of Current (liquid) Assets as recovery of their funds becomes easier if the loan goes sour. For Fixed assets definitely serve as Collateral Security, where a particular equipment or property backs some loans.

Normally, banks don't want their loan to get sour, as such most banks do not want to prefer to extend loan to already indebted businesses entity as loan repayment might get difficult. Also if the business file bankruptcy, and in most cases, the owners do not give any liability to pay them back. Again, if there are any other banks that have lent the business before, the new lender will stand in second position for collateral, resulting in a much lower probability of collecting that loan if it goes sour. Moreover, there is typically a domino effect; if one loan defaults, all default.

The "Credit Philosophy" of most banks is based on the "Five C's of Credit," listed below:

  1. Capacity: Can the borrower repay the loan?
  2. Capital: Has the borrower invested into the business?
  3. Collateral: Can the bank recover the capital from the collateral in case the loan defaults?
  4. Conditions: Is the entity in good shape? Are there regulatory or external factors affecting the borrower?
  5. Character: Credit history of the borrower.

Equity, (Net Worth) of the business, is also very important. Equity is increased with Net Income (Retained Earnings) and Owner's Capital. In other words, if the business owner(s) keep the profit inside the business, equity maintains and grows. However, if they distribute all the profits, equity stays stagnant or decreases. In such case the strength to meet contingencies and business fluctuations becomes very thin or minimum.

Financial Statement -The Dashboard Of Entity's Performance