Summary
Financial statements of three kinds are produced by the typical
UK business
lIncome statement – summarises operating performance for a period.
lBalance sheet – summarises the position at a point in time.
lCash flow statement – summarises cash movements during a period.
The rules of accounting lead to financial statements showing
lA restrictive definition of an asset, tending to mean that assets are
understated.
lOnly aspects measurable in monetary terms.
lA prudent or cautious view of profits and shareholders’ wealth.
lA view that assumes the business is a going concern.
lA view that ignores inflation.
lRevenues as occurring on the date by which the work was done, the revenues’
value is established and there is confidence that the cash will be received.
lA match between revenues and linked expenses in the same accounting
period.
lA view that wealth consists of more than just cash.
Creative accounting
lThere have been recent cases of managers (directors) taking actions to make
businesses appear more buoyant and profitable than they really are.
lThis represents a problem to analysts since it is difficult to know whether a
business’s financial statements are reliable or not.
lSteps have been taken by the relevant regulatory authorities to tighten up the
rules and avoid creative accounting.
Ratio analysis
lCompares two related figures, usually both from the same set of financial
statements.
lAn aid to understanding what the financial statements are saying.
lAn inexact science, so results must be interpreted cautiously.
lSuffers from the weaknesses of financial statements.
lCan be used to predict financial failure – Z-scores.
Ratios are divided into five groups
lProfitability ratios – concerned with effectiveness at generating profit.
lActivity ratios – concerned with efficiency of using assets.
lLiquidity ratios – concerned with the ability to meet short-term debts.
lCapital gearing ratios – concerned with the relationship between equity and
debt financing.
lInvestors’ ratios – concerned with returns to shareholders.