NAME: Mohammed Numan Ahmed
REG NO: EA2452001012170
SUBJECT: FINANCIAL ACCOUNTING
LAQ
Financial Statement Analysis: Its Contribution to Informed Decision-Making by
Various Stakeholders
Financial statement analysis is the process of reviewing and evaluating a company’s financial
statements to make better economic decisions. It helps stakeholders such as investors,
management, creditors, and regulators understand the financial health, profitability, and
viability of a business. By interpreting data from the balance sheet, income statement, cash
flow statement, and statement of equity, stakeholders can assess the company’s
performance and make informed decisions. Below is a detailed explanation of how financial
statement analysis aids various stakeholders, with examples to illustrate its significance.
1. Investors
Investors analyze financial statements to make decisions about buying, holding, or selling
shares. They are primarily concerned with a company’s profitability, growth potential, and
financial stability.
How Financial Statement Analysis Helps Investors:
● Profitability Assessment: Investors use income statements to assess a company’s
ability to generate profit over time. Ratios such as Return on Equity (ROE) and Net
Profit Margin give insights into how effectively a company is managing its resources
to generate profit.
● Risk Evaluation: Investors evaluate balance sheets to understand the company’s
financial position, including the debt-to-equity ratio, which reveals the extent of
financial leverage.
● Growth Potential: By examining the company’s historical performance and trends in
earnings per share (EPS), investors can estimate future growth potential.
Example:
A potential investor might analyze Apple Inc.’s financial statements to decide whether to
purchase shares. If Apple shows a strong ROE and consistent EPS growth, the investor may
consider it a good investment with potential for long-term growth.
2. Management
Company management uses financial statement analysis to assess operational efficiency and
make strategic decisions regarding investments, cost management, and expansion. Financial
ratios help management in benchmarking their performance against industry standards and
internal goals.
How Financial Statement Analysis Helps Management:
● Operational Efficiency: Management uses ratios such as the Operating Margin and
Inventory Turnover Ratio to evaluate how efficiently the company is managing its
resources and controlling costs.
● Decision-Making on Investments: By analyzing the cash flow statement,
management can determine if the company generates enough cash from operations to
invest in new projects or whether external funding is needed.
● Budgeting and Forecasting: Historical financial data aids in forecasting future
revenue and expenses, which is crucial for budget planning and strategic decision-
making.
Example:
If a company's management finds that its gross profit margin has been declining over the
past few quarters, it may investigate operational inefficiencies or consider renegotiating
supplier contracts to improve profitability.
3. Creditors and Lenders
Creditors and lenders, such as banks and financial institutions, rely heavily on financial
statement analysis to assess a company’s ability to repay loans. They are concerned with
liquidity and solvency ratios, which help determine the financial soundness of a business.
How Financial Statement Analysis Helps Creditors:
● Liquidity Evaluation: Creditors use ratios like the Current Ratio and Quick Ratio
to assess whether a company can meet its short-term obligations. A higher ratio
indicates good liquidity, which lowers the risk of default.
● Solvency Assessment: Ratios such as the Debt-to-Equity Ratio and Interest
Coverage Ratio help creditors evaluate the company's long-term solvency and its
ability to meet debt obligations over the long term.
● Cash Flow Stability: By analyzing the cash flow statement, creditors can assess the
company’s ability to generate cash to meet its debt payments.
Example:
A bank may analyze the financial statements of a manufacturing company that has applied for
a loan. If the company has a high interest coverage ratio (indicating sufficient profits to
cover interest expenses) and a strong current ratio, the bank might be more willing to
approve the loan.
4. Employees
Employees and labor unions may be interested in the financial health of a company,
especially if it affects job security, compensation, or bonuses. Financial statement analysis
provides them with insights into the company’s profitability and long-term stability.
How Financial Statement Analysis Helps Employees:
● Job Security: A company with strong profitability and liquidity is more likely to
provide long-term job security for its employees. Employees may analyze the
company’s profitability and solvency ratios to assess the risk of layoffs or
downsizing.
● Compensation Negotiations: Unions and employee representatives might use
financial data to negotiate better wages and benefits. Strong financial performance, as
shown by high profits, may justify increased compensation or bonuses.
Example:
If a company reports strong financial results, employees might push for higher bonuses or
salary increments, arguing that the company can afford to share its profits with its workforce.
5. Suppliers
Suppliers extend credit to companies, so they analyze financial statements to determine
whether the business is financially stable and capable of meeting its payment obligations on
time.
How Financial Statement Analysis Helps Suppliers:
● Creditworthiness: Suppliers analyze the current ratio and accounts payable
turnover to evaluate a company’s ability to pay for supplies and services.
● Financial Stability: Suppliers want to ensure that the company has stable operations
and won’t face insolvency issues, which can be gauged through the debt-to-equity
ratio and the cash flow statement.
Example:
A supplier considering extending credit to a retail chain would review the retailer’s financial
statements. If the accounts payable turnover is favorable and the company has strong cash
flow, the supplier may decide to offer more favorable payment terms.
6. Regulators
Government agencies and regulatory bodies use financial statement analysis to ensure that
companies are complying with laws, regulations, and accounting standards. They also
analyze financial statements to assess the economic impact of the company on the industry
and the economy as a whole.
How Financial Statement Analysis Helps Regulators:
● Compliance Monitoring: Regulators examine financial statements to ensure
compliance with tax laws, securities regulations, and accounting standards (e.g.,
Generally Accepted Accounting Principles (GAAP) or International Financial
Reporting Standards (IFRS)).
● Assessing Financial Stability: For large companies, regulators analyze financial
stability to ensure they do not pose systemic risks to the economy (e.g., in the case of
banks or other financial institutions).
Example:
The Securities and Exchange Commission (SEC) regularly reviews the financial statements
of publicly traded companies to ensure they are transparent and comply with regulatory
standards. If a company’s statements do not adhere to required guidelines, it may be subject
to penalties or legal action.
