Analyzing Financial Statements

Introduction to Finance & Accounting
Analyzing Financial Statements

Running a successful business is not an easy task to undertake. There is always the ???good??? idea to start a new business on. For instance ???I am a great cook and I think I should open a restaurant???. This sounds like a swell idea and in fact friends and family would encourage you to do so, they are there to at least give moral support. People get fired-up and plunge head first into business, not once thinking about the financial and accounting aspects of business. They do not even know that they need to know about finance and accounting. This is the demise of many businesses. They are usually under-funded (No working capital), or they are mismanaged and 80 percent of small businesses fail within the first year due to the above stated mistakes and other considerations ( Finance and accounting help to determine the survival of a business and should be among the basic business operations that should be learned by a new business owner.
There are three major components that form a financial statement and these are the income statement, the balance sheet and the statement of cash flows (Block, S and Hirt, G). Financial statements are directly derived from accounting and these help financial managers, investors, and bankers determine the direction a company is heading in (Block, S and Hirt, G).
Income Statement:
This is a device that measures a firm??™s profitability over a time period whether it is a month, a few months, or even a year (Block, S and Hirt, G). This statement starts with the company??™s sales and then accounts step-by-step expenses such as cost of goods sold, administrative costs, depreciation, interest paid, and taxes paid. This can lead to a profit or loss after all expenses have bee subtracted from total sales numbers (Block, S and Hirt, G). Income statements include calculations for return on capital, earnings per share, and price-earnings ratios. There are limitations to income statements that cannot account for indirect factors such as an increase in the land value of a business, which will increase the value of the company. Income statements only account for actual transactions a company makes (Block, S and Hirt, G).

Balance Sheet:
This indicates what a firm owns and includes how these are financed as liabilities or ownership interest (Block, S and Hirt, G). Balance sheets show the firm??™s holdings and obligations at a certain point in time (an actual date). Balance sheets represent the company??™s transactions since inception and include such entries as plant and equipment, inventory, accounts receivables, and prepaid expenses (Block, S and Hirt, G). Balance sheets are limited because they are based on historical or original cost bases and include inventory and equipment that may have changed in value (Block, S and Hirt, G).
Statement of Cash Flow:
This statement shows the critical nature of cash flow in the company, cash flow being actual cash or equivalents that can easily be converted into cash within 90 days (Block, S and Hirt, G). Statements of Cash flow look deeper beyond balance sheets and income statements to determine what exact cash a company has at a given time. Statements of Cash flow do not use accrual accounting methods to determine how much he company has, but rather accounts for the present monetary value of the company . Cash flows can be determined directly and indirectly from operating, investing, and financing activities.
Depreciation is also a determinant in the finances of a company as it represents the allocation of initial cost of an asset over its useful life (Block, S and Hirt, G). Depreciation is considered to be solely an accounting entry that does not include the direct movement of funds. Depreciation is accounted for in tax credits because a company does not get taxed for the asset being depreciated (Block, S and Hirt, G). Income tax considerations also play a crucial part in business finance and accounting as taxes influence the decisions made in all businesses.
Financial accounting information gives the raw numbers that show whether a company is financially healthy or not. With the information from financial accounting, companies are able to determine precisely where they stand in order to make informed and ethical decisions. In the past decade many companies have made many unethical choices pertaining to accounting practices. Such companies as Enron and Arthur Andersen chose to operate unethically consequently leading to their demise and affecting millions of stockholders in the process. The fact remains that accounting reports were used to determine stock prices of these companies and these accounting records turned out to be bogus. Unethical choices can be made due to greed because accounting reports affect the valuation of companies, thus affecting the prices of stocks that executives of companies hold in their compensation packages.
Financial accounting information also is very instrumental in determining which way the management of a company should go in the future. This information can determine if companies can be bought or sold, if shareholders will receive dividends, and if financial institutions will lend money to a company. Financial accounting information helps companies make informed decisions about their futures and helps the public make informed business decisions on whether to invest in a company or not. Money is the blood of any business and Financial accounting information when reported accurately shows how healthy a company is. Financial accounting information is thus very instrumental in determining the future of any company at any time.

Block, Stanley B and Hirt, Geoffrey A. (2005), Foundations of Financial Management
New York: McGraw-Hill. Retrieved Sept 8, 2008.