CHAPTER – I (Financial Management, Meaning and Scope)

Business concerns need finance to meet their requirements in the economic world. Any kind
of Business Activity depends upon the Finance. Hence it is called the life blood of business
organization. Whether the business concerns are big or small, they need finance to fulfill
their business activities. Hence finance may be called as capital, investment, and fund etc.but
each term us having different meaning and unique characters. Increasing the profit is the
main aim of any kind of economic activity.

Meaning of Finance

Finance may be defined as the art and science of managing money. It includes financial
service and financial instruments. Finance function is the procurement of funds and their
effective utilization in business concerns. The concept of finance includes capital, funds,
money and amount. But each word is having different meaning.

Definition of finance
According to Khan and Jain, “ Finance is the art and art and science of managing money.’’

Definition of Business finance

According to Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall
objectives of the business.”

According to Guthumann & Dougall , “Activity concerned with the planning, raising,
controlling and administering the funds used in the business.”

Finance Functions
The Finance Function is a part of financial management. Financial Management is the
activity concerned with the control and planning of financial resources.

In business, the finance function involves the acquiring and utilization of funds necessary for
efficient operations. Finance is the lifeblood of business without it things wouldn’t run
smoothly. It is the source to run any organization, it provides the money, it acquires the
money.

Objectives of Finance Functions

Investment Decisions– This is where the finance manager decides where to put the company
funds. Investment decisions relating to the management of working capital, capital budgeting
decisions, management of mergers, buying or leasing of assets. Investment decisions should
create revenue, profits and save costs.

Financing Decisions– Here a company decides where to raise funds from. They are two
main sources to consider mainly equity and borrowed. From the two a decision on the
appropriate mix of short and long-term financing should be made. The sources of financing
best at a given time should also be agreed upon.

Dividend Decisions– These are decisions as to how much, how frequent and in what form to
return cash to owners. A balance between profits retained and the amount paid out as
dividends should be decided here.

Liquidity Decisions– Liquidity means that a firm has enough money to pay its bills when
they are due and have sufficient cash reserves to meet unforeseen emergencies. This
decision involves the management of the current assets so you don’t become insolvent or fail
to make payments.

To Establish a Business– Without money, you cannot get labor, land and so on with the
finance function you can determine what is required to start your business and plan for it.

To Run a Business– To remain in business you must cater to the day to day operating costs
such as paying salaries, buying stationery, raw material, the finance function ensures you
always have adequate funds to cater to this.

To Expand, Modernize, Diversify– A business needs to grow otherwise it may become

redundant in no time. With the finance function, you can determine and acquire the funds
required to do so.

Purchase Assets-You need money to purchase assets. This can be tangible assets like
furniture, buildings or intangible like trademarks, patents, etc. to get this you need finances.

The Role / Importance of the Finance Function

Identify Need of Finance-To starts a business you need to know how much is required to
open it. So, the finance function helps you know how much the initial capital is, how much of
it you have and how much you need to raise.

Identify Sources of Finance-Once you know what needs to be raised you look at areas you
can raise these funds from. You can borrow or get from various shareholders.

Comparison of Various Sources of Finance– After identifying various fund sources

compare the cost and risk involved. Then choose the best source of financing that suits your
business needs.

Investment-Once the funds are raised it is time to invest them. Investment decisions should
be done in a manner that a business gets higher returns. Cost of funds procurement should be
lower than the return on investment, this will show a wise investment was made.

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

According to J.F. Bradely, “The area of business management devoted to a judicious use of
capital and a careful selection of sources of capital in order to enable a spending unit to move
in the direction of reaching its goals.”

According to J.L Massie, “ Operational activity of a business that is responsible for

obtaining and affectively utilising the funds necessary for efficient operations.”

Scope/Elements
Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions.

Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.

Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:

Dividend for shareholders- Dividend and the rate of it has to be decided.

Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. Profit maximization

Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern.

The finance manager tries to earn maximum profits for the company in the short-term and the
long-term. He cannot guarantee profits in the long term because of business uncertainties.
However, a company can earn maximum profits even in the long-term, if:

• The Finance manager takes proper financial decisions

• He uses the finance of the company properly

2. Wealth maximization
Wealth maximization (shareholders’ value maximization) is also a main objective of financial
management. Wealth maximization means to earn maximum wealth for the shareholders. So,
the finance manager tries to give a maximum dividend to the shareholders. He also tries to
increase the market value of the shares. The market value of the shares is directly related to
the performance of the company. Better the performance, higher is the market value of shares
and vice-versa. So, the finance manager must try to maximize shareholder’s value

3. Proper estimation of total financial requirements

Proper estimation of total financial requirements is a very important objective of financial

management. The finance manager must estimate the total financial requirements of the
company. He must find out how much finance is required to start and run the company. He
must find out the fixed capital and working capital requirements of the company. His
estimation must be correct. If not, there will be shortage or surplus of finance. Estimating the
financial requirements is a very difficult job. The finance manager must consider many
factors, such as the type of technology used by company, number of employees employed,
scale of operations, legal requirements, etc.

4. Proper mobilization

Mobilization (collection) of finance is an important objective of financial management. After

estimating the financial requirements, the finance manager must decide about the sources of
finance. He can collect finance from many sources such as shares, debentures, bank loans,
etc. There must be a proper balance between owned finance and borrowed finance. The
company must borrow money at a low rate of interest.

5. Proper utilization of finance

Proper utilization of finance is an important objective of financial management. The finance

manager must make optimum utilization of finance. He must use the finance profitable. He
must not waste the finance of the company. He must not invest the company’s finance in
unprofitable projects. He must not block the company’s finance in inventories. He must have
a short credit period.

6. Maintaining proper cash flow

Maintaining proper cash flow is a short-term objective of financial management. The

company must have a proper cash flow to pay the day-to-day expenses such as purchase of
raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a
good cash flow, it can take advantage of many opportunities such as getting cash discounts on
purchases, large-scale purchasing, giving credit to customers, etc. A healthy cash flow
improves the chances of survival and success of the company.

7. Survival of company

Survival is the most important objective of financial management. The company must survive
in this competitive business world. The finance manager must be very careful while making
financial decisions. One wrong decision can make the company sick, and it will close down.
8. Creating reserves

One of the objectives of financial management is to create reserves. The company must not
distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as
reserves. Reserves can be used for future growth and expansion. It can also be used to face
contingencies in the future.

9. Proper coordination

Financial management must try to have proper coordination between the finance department
and other departments of the company.

10. Create goodwill

Financial management must try to create goodwill for the company. It must improve the
image and reputation of the company. Goodwill helps the company to survive in the short-
term and succeed in the long-term. It also helps the company during bad times.

11. Increase efficiency

Financial management also tries to increase the efficiency of all the departments of the
company. Proper distribution of finance to all the departments will increase the efficiency of
the entire company.

12. Financial discipline

Financial management also tries to create a financial discipline. Financial discipline means:

• To invest finance only in productive areas. This will bring high returns (profits) to the
company.
• To avoid wastage and misuse of finance.

13. Reduce cost of capital

Financial management tries to reduce the cost of capital. That is, it tries to borrow money at a
low rate of interest. The finance manager must plan the capital structure in such a way that
the cost of capital it minimized.

14. Reduce operating risks

Financial management also tries to reduce the operating risks. There are many risks and
uncertainties in a business. The finance manager must take steps to reduce these risks. He
must avoid high-risk projects. He must also take proper insurance.

15. Prepare capital structure

Financial management also prepares the capital structure. It decides the ratio between owned
finance and borrowed finance. It brings a proper balance between the different sources of
capital. This balance is necessary for liquidity, economy, flexibility and stability.
Functions of Financial Management
Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.

Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.

Choice of sources of funds: For additional funds to be procured, a company has many
choices like-

• Issue of shares and debentures

• Loans to be taken from banks and financial institutions
• Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.

Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.

Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:

Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.

Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.

Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.

Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Role of a Financial Manager/ Functions of Financial Manager

Financial activities of a firm is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager performs all the
requisite financial activities.
A financial manger is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that
the funds are utilized in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain a
good balance between equity and debt.

Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate
the funds. The funds should be allocated in such a manner that they are optimally used. In
order to allocate funds in the best possible manner the following point must be considered

The size of the firm and its growth capability

Status of assets whether they are long-term or short-term

Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important
activity

Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the economy,
mechanism of demand and supply, cost and output. A healthy mix of variable and fixed
factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery.
In order to maintain a tandem it is important to continuously value the depreciation cost of
fixed cost of production. An opportunity cost must be calculated in order to replace those
factors of production which has gone thrown wear and tear. If this is not noted then these
fixed cost can cause huge fluctuations in profit.

Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important function
of a financial manager. When securities are traded on stock market there involves a huge
amount of risk involved. Therefore a financial manger understands and calculates the risk
involved in this trading of shares and debentures.

Its on the discretion of a financial manager as to how to distribute the profits. Many investors
do not like the firm to distribute the profits amongst share holders as dividend instead invest
in the business itself to enhance growth. The practices of a financial manager directly impact
the operation in capital market.
Chapter –II (Financial Statement Analysis and Interpretation)

Meaning of Financial Statement

A financial statement is a collection of data organized according to logical and consistent

accounting procedures. Its purpose is to convey an understanding of some financial aspects of
a business firm. It may show a position at a moment in time, as in the case of a balance sheet,
or may reveal a series of activities over a given period of time, as in the case of an income
statement.

Financial statements are written record that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or Investing purpose.

Definitions of Financial Statements

Financial statements are the outcome of summarizing process of accounting. In the words of
John N. Myer, “The financial statements provide a summary of the accounts of a business
enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date
and the income statement showing the results of operations during a certain period.”
Financial statements are prepared as an end result of financial accounting and are the major
sources of financial information of an enterprise.

Smith and Asburne define financial statements as, “the end product of financial accounting
in a set of financial statements prepared by the accountant of a business enterprise-that
purport to reveal the financial position of the enterprise, the result of its recent activities, and
an analysis of what has been done with earnings.”

Financial statements are also called financial reports. In the words of Anthony ” Financial
statements, essentially, are interim reports, presented annually and reflect a division of the
life of an enterprise into more or less arbitrary accounting period-more frequently a year.”

Financial statements are the basis for decision making by the management as well as other
outsiders who are interested in the affairs of the firm such as investors, creditors, customers,
suppliers, financial institutions, employees, potential investors, government and the general
public.

Types of Financial statements

Financial statements include:

• Balance sheet
• Income statement
• Cash flow statement.
• Changes in Owner’s Equity

Financial statements are written records that convey the business activities and the financial
performance of a company.

The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a
snapshot in time.

The income statement primarily focuses on a company’s revenues and expenses during a
particular period. Once expenses are subtracted from revenues, the statement produces a
company's profit figure called net income.

The cash flow statement (CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments.

1. Statement of Financial Position/ Balance sheet

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of the following three elements:

• Assets: Something a business owns or controls (e.g. cash, inventory, plant and
machinery, etc)
• Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
• Equity: What the business owes to its owners. This represents the amount of capital
that remains in the business after its assets are used to pay off its outstanding
liabilities. Equity therefore represents the difference between the assets and liabilities.

2. Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the company's
financial performance in terms of net profit or loss over a specified period. Income Statement
is composed of the following two elements:

• Income: What the business has earned over a period (e.g. sales revenue, dividend
income, etc)
• Expense: The cost incurred by the business over a period (e.g. salaries and wages,
depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The
movement in cash flows is classified into the following segments:

• Operating Activities: Represents the cash flow from primary activities of a business.
• Investing Activities: Represents cash flow from the purchase and sale of assets other
than inventories (e.g. purchase of a factory plant)
• Financing Activities: Represents cash flow generated or spent on raising and
repaying share capital and debt together with the payments of interest and dividends.

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details
the movement in owners' equity over a period. The movement in owners' equity is derived
from the following components:

• Net Profit or loss during the period as reported in the income statement
• Share capital issued or repaid during the period
• Dividend payments
• Gains or losses recognized directly in equity (e.g. revaluation surpluses)
• Effects of a change in accounting policy or correction of accounting error

Nature of Financial Statement

The following points explain the nature of financial statements:

1. Recorded Facts:

The term ‘recorded facts’ refers to the data taken out from the accounting records. The
records are maintained on the basis of actual cost data. The figures of various accounts such
as cash in hand, cash in bank, bills receivables, sundry debtors, fixed assets etc. are taken as
per the figures recorded in the accounting books. The assets purchased at different times and
at different prices are put together and shown at cost prices. As recorded facts are not based
on replacement costs, the financial statements do not show current financial condition of the
concern.
2. Accounting Conventions:

Certain accounting conventions are followed while preparing financial statements. The
convention of valuing inventory at cost or market price, whichever is lower, is followed. The
valuing of assets at cost less depreciation principle for balance sheet purposes is followed.

The convention of materiality is followed in dealing with small items like pencils, pens,
postage stamps, etc. These items are treated as expenditure in the year in which they are
purchased even though they are assets in nature. The stationery is valued at cost and not on
the principle of cost or market price whichever is less. The use of accounting conventions
makes financial statements comparable, simple and realistic.

3. Postulates:

The accountant makes certain assumptions while making accounting records. One of these
assumptions is that the enterprise is treated as a going concern. So the assets are shown on a
going concern basis. Another important assumption is to presume that the value of money
will remain the same in different periods.

Though there is a drastic change in purchasing power of money the assets purchased at
different times will be shown at the amount paid for them. While preparing profit and loss
account, the revenue is treated in the year in which the sale was undertaken even though the
sale price may be received in a number of years. The assumption is known as realization
postulate.

4. Personal Judgments:

Even though certain standard accounting conventions are followed in preparing financial
statements but still personal judgment of the accountant plays an important part. For example,
in applying the cost or market value whichever is less to inventory valuation the accountant
will have to use his judgment in computing the cost in a particular case. There are a number
of methods for valuing stock, viz.; last in first out, first in first out, average cost method,
standard cost, base stock method, etc.

Objectives of Financial Statements:

Financial statements are the sources of information on the basis of which conclusions are
drawn about the profitability and financial position of a concern. They are the major means
employed by firms to present their financial situation of owners, creditors and the general
public. The primary objective of financial statements is to assist in decision making.

i. To provide reliable financial information about economic resources and obligations of

a business firm.
ii. To provide other needed information about changes in such economic resources and
obligations.
iii. To provide reliable information about changes in net resources (resources less
obligations) arising out of business activities.
iv. To provide financial information that assists in estimating the earning potentials of
business.
 v. To disclose, to the extent possible, other information related to the financial
statements that is relevant to the needs of the users of these statements.

Financial Statement Analysis

Financial statement analysis (or financial analysis) is the process of reviewing and analyzing
a company's financial statements to make better economic decisions.

Financial statement analysis involves using financial data to assess a company’s performance
and make recommendations about how it can improve going forward.

Financial Statement can only help in decision making if these statements are analysed
properly. Metcalf & Titard has defined , analyzing Financial statements as, “ is a process of
evaluating the relationship between components parts of a Financial Statement to obtain a
better understanding of a firm’s Financial position & Performance.”

Types of Financial Statement Analysis

The most common types of financial analysis are:

• External Analysis
• Internal Analysis
• Vertical Analysis
• Horizontal Analysis

1. External Analysis
The Outsiders means the public at large who might be already shareholders or debt
holders might like to invest in the company & Government & Financial Institutions
Analyze the companies statement published in the newspaper, prospectus or brochure.
2. Internal Analysis
The Executives and employees who have an access to the Internal Accounting record
of a company analyse the Financial statement . The certain Government Agencies
under rule are also authorized to inspect the Financial Statement & can analyze them.

3. Vertical Analysis

This type of financial analysis involves looking at various components of the income
statement and dividing them by revenue to express them as a percentage. For this
exercise to be most effective, the results should be benchmarked against other
companies in the same industry to see how well the company is performing.
 This process is also sometimes called a common sized income statement & Balance
sheet as it allows an analyst to compare companies of different sizes by evaluating
their margins instead of their Rupees.

Vertical Analysis is also known as Common size statement.

4. Horizontal Analysis

This process involves taking several years of financial data and comparing them to
each other as a growth rate. This will help an analyst determine if a company is
growing or declining and identify important trends.

When building financial models, there will typically be at last three years of historical
financial information and five years of forecasted information. It provides 8+ years of
data to perform a meaningful trend analysis, which can be benchmarked against other
companies in the same industry.

Horizontal Analysis is also known as Comparative Statements.

Tools and Techniques of Financial Statement Analysis

1. Comparative Statement or Comparative Financial and Operating Statements.

2. Common Size Statements.
3. Trend Ratios or Trend Analysis.
4. Average Analysis.
5. Statement of Changes in Working Capital.
6. Fund Flow Analysis.
7. Cash Flow Analysis.
8. Ratio Analysis.

A brief explanation of the tools or techniques of financial statement analysis presented below.

1. Comparative Statements
Comparative statements deal with the comparison of different items of the Profit and Loss
Account and Balance Sheets of two or more periods. Separate comparative statements are
prepared for Profit and Loss Account as Comparative Income Statement and for Balance
Sheets.

As a rule, any financial statement can be presented in the form of comparative statement such
as comparative balance sheet, comparative profit and loss account, comparative cost of
production statement, comparative statement of working capital and the like.

• Comparative Income Statement

 Three important information are obtained from the Comparative Income Statement.
They are Gross Profit, Operating Profit and Net Profit. The changes or the
improvement in the profitability of the business concern is find out over a period of
time. If the changes or improvement is not satisfactory, the management can find out
the reasons for it and some corrective action can be taken.

• Comparative Balance Sheet

The financial condition of the business concern can be find out by preparing
comparative balance sheet. The various items of Balance sheet for two different
periods are used. The assets are classified as current assets and fixed assets for
comparison. Likewise, the liabilities are classified as current liabilities, long term
liabilities and shareholders’ net worth. The term shareholders’ net worth includes
Equity Share Capital, Preference Share Capital, Reserves and Surplus and the like.

2. Common Size Statements

A vertical presentation of financial information is followed for preparing common-size

statements. Besides, the rupee value of financial statement contents are not taken into
consideration. But, only percentage is considered for preparing common size statement.

The total assets or total liabilities or sales is taken as 100 and the balance items are compared
to the total assets, total liabilities or sales in terms of percentage. Thus, a common size
statement shows the relation of each component to the whole. Separate common size
statement is prepared for profit and loss account as Common Size Income Statement and for
balance sheet as Common Size Balance Sheet.

3. Trend Analysis
The ratios of different items for various periods are find out and then compared under this
analysis. The analysis of the ratios over a period of years gives an idea of whether the
business concern is trending upward or downward. This analysis is otherwise called
as Pyramid Method.

4. Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared
with industry average. These both trends can be presented on the graph paper also in the
shape of curves. This presentation of facts in the shape of pictures makes the analysis and
comparison more comprehensive and impressive.

5. Statement of Changes in Working Capital

The extent of increase or decrease of working capital is identified by preparing the statement
of changes in working capital. The amount of net working capital is calculated by subtracting
the sum of current liabilities from the sum of current assets. It does not detail the reasons for
changes in working capital.
6. Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds of the business
concern for a specific period. It indicates where funds come from and how they are used
during the period under review. It highlights the changes in the financial structure of the
company.

7. Cash Flow Analysis

Cash flow analysis is based on the movement of cash and bank balances. In other words, the
movement of cash instead of movement of working capital would be considered in the cash
flow analysis. There are two types of cash flows. They are actual cash flows and notional
cash flows.

8. Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship between individual items
(or group of items) in the balance sheet or profit and loss account. Ratio analysis is not only
useful to internal parties of business concern but also useful to external parties. Ratio analysis
highlights the liquidity, solvency, profitability and capital gearing.

Limitations of Financial Statement Analysis

Dependence on historical costs. Transactions are initially recorded at their cost. This is a
concern when reviewing the balance sheet, where the values of assets and liabilities may
change over time. Some items, such as marketable securities, are altered to match changes in
their market values, but other items, such as fixed assets, do not change. Thus, the balance
sheet could be misleading if a large part of the amount presented is based on historical costs.

Inflationary effects. If the inflation rate is relatively high, the amounts associated with assets
and liabilities in the balance sheet will appear inordinately low, since they are not being
adjusted for inflation. This mostly applies to long-term assets.

Intangible assets not recorded. Many intangible assets are not recorded as assets. Instead,
any expenditures made to create an intangible asset are immediately charged to expense. This
policy can drastically underestimate the value of a business, especially one that has spent a
large amount to build up a brand image or to develop new products. It is a particular problem
for startup companies that have created intellectual property, but which have so far generated
minimal sales.

Based on specific time period. A user of financial statements can gain an incorrect view of
the financial results or cash flows of a business by only looking at one reporting period. Any
one period may vary from the normal operating results of a business, perhaps due to a sudden
spike in sales or seasonality effects. It is better to view a large number of consecutive
financial statements to gain a better view of ongoing results.

Not always comparable across companies. If a user wants to compare the results of different
companies, their financial statements are not always comparable, because the entities use
different accounting practices. These issues can be located by examining the disclosures that
accompany the financial statements.

Subject to fraud. The management team of a company may deliberately skew the results
presented. This situation can arise when there is undue pressure to report excellent results,
such as when a bonus plan calls for payouts only if the reported sales level increases. One
might suspect the presence of this issue when the reported results spike to a level exceeding
the industry norm.

No discussion of non-financial issues. The financial statements do not address non-financial

issues, such as the environmental attentiveness of a company's operations, or how well it
works with the local community. A business reporting excellent financial results might be a
failure in these other areas.
Not verified. If the financial statements have not been audited, this means that no one has
examined the accounting policies, practices, and controls of the issuer to ensure that it has
created accurate financial statements. An audit opinion that accompanies the financial
statements is evidence of such a review.

No predictive value. The information in a set of financial statements provides information

about either historical results or the financial status of a business as of a specific date. The
statements do not necessarily provide any value in predicting what will happen in the future.
For example, a business could report excellent results in one month, and no sales at all in the
next month, because a contract on which it was relying has ended.