As we learned in Chapter I., many external decision makers use financial statements in making finalcial decisions-that is, in selecting those companies in which they will invest resources or to which they will extend credit. For this reason, financial statements are designed primarily to meet the needs of creditors and investors. Two factors of concern to creditors and investors are’ the solvency and profitability of a business organization.
Creditors arethterested in solvency=-the ability of the business to pay its debts as they come due. Business concerns that are able to pay their debts promptly arc said to be solvent. In contrast, a company that finds itself unable to meet its obligations as they fall due is called insolvent. Solvency is critical to the very survival of a business organization- a business that becomes insolvent may be forced into hankruptcy by its crcditors. Once bankrupt, a business may be forced by the courts to stop its operations. sell its assets (for the purpose of paying its creditors), and end its existence.
Investors also are interested in the solvency ofa ‘business organization. but they arc even more interested in its profitability. Profitable operations increase the mille of the owners’ equity in the business. A company that continually operates unprofitably will eventually exhaust its resources and be forced out of existence. Therefore. most users of financial statements study these statements carefully for clues to the company ssolvency and future profitability.
Evaluating Short-Term Solvency
One key indicator of short-term solvency is the relationship between an entity’s liquid assets and the liabilities requiring payment in the near future. By studying the nature of a company’s assets, and the amounts and due dates of its liabilities, users of financial statements often may anticipate whether the company is likely to have difficulty in meeting its upcoming obligations. This simple type of analysis meets the needs of many short-term creditors. Evaluating long-term solvency is a more difficult matter and is discussed in later chapters.
Management’s Interest in Financial Statements
The management of a business organization is vitally concerned with the financial. position of the business and with its profitability and cash flows. management is anxious to receive financial statements as frequently an~ as quickly as possible ,0 that it may take action to improve areas of weak performance. Most large organizations. provide managers with financial statements on at least a monthly basis. With modern ‘ technology, financial statements prepared 00 a weekly. daily. or even hourly basis are possible
Managers have a special interest in the annual financial statements. as these are the statements most widely used by decision makers outside of the organization. For example, if creditors view the apnual financial statements as strong -.they will be more willing to extend credit to the business than if they regard the company’s financial statements as weak
A strong statement of. financial position is one that shows relatively little debt and large amounts of liquid assets relative to the liabilities due in the near future. A strong income statement is one that shows large revenues relative to the expenses required to earn the revenues. A strong statement of cash flows is one that not only shows a strong cash balance but also indicates that cash is being generated by operations. Demonstrating through the financial statements that these characteristics of the company are ongoing and can be seen in a series of financial statements is particularly helpful in creating confidence in the company on the part of investors and creditors. ‘Because of the im- .portance of the financial statements, management may take steps that are specifically intended to improve the company’s financial position and financial performance. For example, cash purchases of assets may be delayed until the beginning of [he next accounting period so that large amounts of cash will be included in the statement of financial position and the statement of cash flows. On the other hand, if the company is’ in a particularfy strong cash position, liabilities due tin the near future may be paid, replaced with longer-term liabilities, or even replaced by additional investments by owners in order to communicate that negative cash flows in the f,ijlllrewill not be as great as they would otherwise appear
These actions are sometimes called taken by management to make the company appear as strong as possible in its financial statements. Users of financial statements should realize that. while the statements arc fair representations of the financial position atthe end of the period and financial performance over the period. they may not necessarily describe the typical financial situation of the business. In its annual financial statements, in particular, management tries to “put its best’ foot forward” and make the company appear as strong as is reasonably possible. As a result. many creditors regard more frequent financial statements (for example. quarterly or even monthly) as providing important additional information beyond that in the annual tinancial statements