Using financial statements

The culmination of the accounting process is the production of the financial statements. And then the real fun begins, the analysis of those financial statements. Users of those financial statements examine those statements to see trends over time. For example, analysis of Walmart's income statement for the year ended January 31st, 2019 reveals that the company's sales increased 2.9% during 2018. Not bad. 

Users of financial statements also use those statements to compare different companies. So at the same time Walmart's sales were going up 2.9%, Target's sales were going up by 3.6%. And Amazon's sales were increasing by a whopping 31%. Users of financial statements also use those statements to compute a variety of financial ratios. A financial ratio is simply one financial statement number divided by another. For example, Walmart's cost of sales divided by its sales tells you the average Walmart purchase cost as a percentage of Walmart's retail selling price. During 2018, that percentage was 75%, meaning that if Walmart sells you something for $100, that item cost Walmart on average $75 to buy. The corresponding number for Target was 71%. Hmm, is Target able to buy things for less than Walmart buys those same things? Or are Target's selling prices higher, or does Target sell a different mix of items? I don't know. Analysis of financial statements doesn't typically answer all your questions about a company, but that analysis does highlight interesting areas for further investigation.

The key users of financial accounting data are lenders and investors, the people who provide the capital to a business so that an entrepreneur can turn her or his dreams into reality. Lenders are interested in the ability of a company to be able to repay its loans, so lenders will look at the amount of a company's borrowing relative to the amount of the company's assets. If the borrowing level is too high, the lender gets nervous. Lenders are also very interested in a company's operating cash flows. Will the company be able to generate enough cash from its operations to repay its loans? Investors are interested in forecasting a company's future profitability. When an investor buys a company, the investor is buying the company's future, not the past. Investors also look at relations between the size of a company's profits and the market value of that company. For example, in 2019, Walmart's total market value, called its market capitalization, was 40 times as much as the company's reported net income. This is called the price earnings or PE ratio. Target's PE ratio was just 15. Hmm, now, this means for the same level of current net income, Walmart is more valuable than Target. Why? Again, analysis of financial statements doesn't answer all your questions about a company, but it does highlight interesting areas for further investigation. Now, we're going to look at this PE ratio in a future module. Lenders and investors aren't the only external users of financial data. For example, suppliers use a company's financial statements. If I'm going to sell to you on credit, then I want to know if you're going to be able to repay me or not. Customers also use a company's financial statements. Anybody who enters into a long-term relationship with a business wants to know if that business is going to be around in the future. Employees should also look at a company's financial statements. Employees have long-term relationships with companies. Before leaving one job and taking another job with a different company, employees should look at the financial reports of the new company. Lots of people use external financial accounting reports. Investors, lenders, suppliers, customers, employees, competitors, government agencies, politicians, news reporters. As accountants, we enjoy operating the accounting process and creating the financial statements. But the important end result is not making financial statements. It is using financial statements to understand a company and where it fits in its competitive environment.