Strengths and Weaknesses of Financial Statement

Q1. Discuss the strengths and weaknesses of financial statements in assisting you as you try to determine the stability and growth potential of possible suppliers.

The financial statements of the potential parts suppliers can provide a great deal of information that can assist the management of manufacturer company in making informed decisions about whether those suppliers would be able to meet their responsibilities timely. Being a user of the financial statement, the manufacturer company looking for a suitable supplier can get immense information about the strengths and weaknesses of the suppliers just by looking and analyzing the information presented in those financial statements (Pandey, 2005). Following are the strengths and weaknesses of the statement of financial performance in this regard.

Strengths

  • Financial statement analysis can provide information about the financial stability and solvency of the company with various measures such as current ratio, gearing etc.
  • Financial statement analysis can also provide useful information as regards the liquidity of the company and its cash cycle, such as debtor creditor turnover ratios, and cash flows from investing, financing and operating activities of the company.
  • Capital structure of the company can be evaluated, such as whether the company is highly geared or not and whether it can take advantage of the financial leverage.
  • Financial statement analysis also have detailed information regarding the company’s business activities during the period, its potential business prospects, ongoing litigations and claims against the company and its possible impact on the financial position of the company, as well as the growth potential of the company in future.
  • Financial statement analysis also have information regarding the current finance providers of the company, what assets are mortgaged or hypothecated, and whether the company is meeting its current financial obligations.
  • A detailed analysis of the above information can help in assessing whether the financial performance of the company has improved, deteriorated or remained constant over an extended period of time.

Using the information above the manufacturer company can use various ratio analysis techniques such as past ratios, competitor ratios, industry ratios, projected ratios and time series analysis to evaluate the business and financial performance of supplier various alternatives and competitors (Pandey, 2005). This financial analysis will serve as the starting point in the selecting of the appropriate and most suitable supplier that can best serve the needs of manufacturer company.

 

Weaknesses

There are some limitations inherent in the process through which financial statements are prepared. These limitations are discussed later in Question 3. Apart from these the following weaknesses are present in the financial statements analysis of the suppliers.

  1. Financial statements are prepared by the management of the company and therefore they might be overoptimistic or not present a true and fair view of the company’s business affairs.
  2. Financial statements would not provide information regarding the supply rates offered by the company to its customers and other allied price and market information that can help making purchase decisions.
  3. Financial statements may not give the indications of future market and economic fluctuations and indicators which may affect the financial performance of the suppliers in future.
  4. Financial statements may lack additional information that might be needed in decision making such as product quality and durability.

 

Q2. What can you learn about a company from a standard set of financial statements?

A standard set of financial statements can provide a great deal of information about the company’s business affairs and dealings using the following statements:

  1. Statement of Financial Position or Balance Sheet
  2. Statement of Comprehensive Income or Profit and Loss Account
  3. Statement of Cash Flows
  4. Statement of Changes in Equity (IASB, 2007).

Using these statements, a user is able to extract the following information for further analysis about the company.

  1. Background information about the company, when it was incorporated and what are the businesses it engages in, and where does its business objectives extend.
  2. Information about assets and liabilities of the company including property plant and equipment, stock, debtors cash and bank balances; as well as loans and leases from banks, financial liabilities, creditors and commitments and guarantees undertaken.
  3. Revenue earned, expenditures incurred, finance costs paid to banks and financial institutions, profits earned and taxed paid to revenue authorities.
  4. Changes in the equity structure of the company.
  5. Cash inflows and outflows from various operating, financing and investing activities.
  6. Disclosures required by accounting standards and regulatory authorities such as those relating to transactions with related parties and associated business entities (IASB, 2009).
  7. Exceptional comments or matters requiring special attention as presented by the auditors and directors in their respective reports (Peterson & Fabozzi, 1999).

 

Q3. What are the limitations of financial statements?

The methods accordingly to which financial information is accounted for, recorded and later reported in financial statements is largely subjective and requires estimation techniques and subjective evaluation.    The analysts of this financial information therefore should be aware of these inherent limitations in the financial information compilation process (Koen & Oberholster, 1999). These include:

  1. Limitations of Accounting Frameworks – These include US GAAP and IFRSs. The purpose of these financial reporting frameworks is to ensure consistent and comparable financial information. But many areas are subjective and requires application of management judgment (Koen & Oberholster, 1999).
  2. Dependence on Historical Costs – A large area of financial statements is based on the historical costs on which assets were acquired. This neglects the possibility of the change in value of the assets over time.
  3. Inflationary Effects – The assets and liabilities stated at the financial reporting date does not take into account the inflationary effects of prices. As a result the value of assets and liabilities may become understated. IFRS controls this through IAS 29 – Financial Reporting in Hyperinflationary Economies (IASB, 2009).
  4. Non-comparable at times – Because the accounting frameworks allow the management to apply different policies for accounting of different assets and liabilities, there is a possibility that some aspects financial statements may not be comparable across different companies and industries due to differences in accounting policies (Accounting Tools, 2015).
  5. Possibility of Fraud – Management may be inclined to report excellent results due to various reasons, for example, pressure from financers or shareholders. Hence there is always a risk of management manipulation of financial results.