Study Notes: Business Finance & Accounting

Using financial statements to assess business performance

The balance sheet and income statement provide much useful information for a user of accounts to better understand how the business is doing. Some useful analytical tasks would include:

Comparing performance over time:

A danger with just looking at one year’s results is that the numbers can hide a longer term issue in the business.

By looking at data over several years, it is possible to see whether a trend is emerging.  Public companies in the UK are required to publish a five-year summary of the income statement to help shareholders assess trends.

Comparing performance against competitors or the industry as a whole:

Assuming that the detailed information is available, a comparison against competitors provides a useful way for management and shareholders to assess relative performance.

Has the business’ revenues grown as fast as close competitors? How has the business performed compared with the market as a whole?

Benchmarking against best-in-class businesses:

Comparison against other businesses who are not direct competitors can also be useful – particularly if they help set the standard that the business aims to achieve.  Care has to be taken with this, though. The benchmark business might operate in a very different industry, with significantly different profit margins and balance sheet norms.

Potential weaknesses in using published financial information to assess performance

It is worth remembering some of the potential problems that can arise when using the income statement and balance sheet to assess performance.  Two in particular:

• Valuing some assets and liabilities on the balance sheet involves subjective judgement.  For example, management have some discretion about what provisions they need to make for trade debtors that may not pay or for obsolete stocks.
• Accounts are largely descriptive about what has occurred in the past – rather than explaining why.  Publicly quoted companies are required to provide much more detailed commentary on the financial statements in the Annual Report. However, the vast majority of companies are not publicly quoted!