Uses and Limitations of

Financial Statements
Uses of Financial Statements

1. Bridging the Gap in Management

Financial statements basically reflect a company’s financial performance. They show the profits and liabilities of
the business. They show how successful a company’s decisions have been. Since shareholders have access to
these statements, they can gauge their company’s performance. This further helps in bridging the gap between
lapses in management and the expectations of owners.

2. Availing Credit from Lenders

Every business needs to borrow funds for functioning. They have to rely on lenders like banks and financial
institutions for this purpose. Financial statements play a huge role in this purpose. Since they show a company’s
liabilities, debts and profits, investors can use them to make informed decisions.

3. Use for Investors

Investors also extensively use a company’s financial statements to assess its finances. That helps them figure out
how the company’s solvency will be in the longer term. Thus, the better a company’s financial position is, the
greater the investment it will receive.
Uses of Financial Statements
4. Use for Government
Governmental policies pertaining to corporates depend heavily on financial statements. This is because these
statements depict how companies are functioning in general. The government can use this information to decide
taxation and regulatory policies.

5. Use for Stock Exchanges

Regulatory bodies like SEBI and stock exchanges like BSE and NSE also use financial statements for many
reasons. SEBI can assess a company’s internal matters using them to ensure the protection of investors. Even
stock advisers require them to frame their quotes. They are also a great source of information for stock traders and
investors.

6. Information on Investments
The shareholders of a company rely on these statements to understand how their investments are paying off. If a
company is earning profits, it might decide to invest even more money. On the contrary, stagnant profits or even
losses will prompt them to pull out. Despite all these uses of financial statements, there are some limitations to
them as well.
Limitations of Financial Statements
Ratio Analysis
Ratio
Is a mathematical relationship between two
numbers and is commonly expressed in
percentages and decimals.
Example: Kilo of rice the family received during a
pandemic.
Financial Ratios
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
Financial Ratios
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
Liquidity Ratios

Determine a company’s ability to cover short-term

obligations and cash flows.
Liquidity Ratios
1. Current Ratio
2. Quick Ratio
3. Receivable Turnover
4. Inventory Turnover
Current Ratio – a.k.a as working capital ratio. Is one
way to assess the overall liquidity of a company by comparing current
assets to current liabilities

Acceptable current ratio: 1.5 to 3.0

Quick Ratio – a.k.a as acid test ratio. is more
conservative in the sense that it does not include
all current assets in the computation.

Quick Assets are (1) Cash, (2) Receivables, (3) Marketable Securities (Short Term Investment)
Acceptable Quick Ratio: 1.0
 Accounts Receivable Turnover – is the
number of times that the receivables on credit
sales are collected.

Net Credit Sales – sales on credit, in the absence of sales, are considered
Average Receivables – Beginning AR + Ending AR divided by 2 (in the absence of beginning and ending AR, AR is acceptable.
*Acceptable Ratio: the higher the better.
Age of Receivables – the time period
when the receivables are materialized.

Acceptable: the faster the better.

 Inventory Turnover – is the number of times
that the inventory is sold during the accounting
period.

Average Inventory – Beginning Inventory + Ending Inventory divided by 2 (in the absence of beginning and ending Inv, INV is acceptable.
*Acceptable Ratio: the higher the better.
Age of Inventory – identify the age
of sales in the warehouse

*Acceptable Ratio: the higher the better.

Financial Ratios
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
Solvency Ratio –is a key metric used to measure an enterprise’s
ability to meet its debt obligations and is used often by prospective business
lenders. It indicates whether a company’s cash flow is sufficient to meet its
short & long term liabilities. a.k.a. stability ratio

1. Time Interest Earned

2. Debt Ratio

3. Equity Ratio

4. Debt to Equity Ratio

5. Equity to Debt Ratio

 Time Interest Earned – it evaluates the
ability of a company to pay interest on its debt.

Source of Information: Statement of Comprehensive Income

 Debt Ratio – measures the percentage
of assets funded by creditors

Source of Information: Statement of Financial Position

 Equity Ratio – indicates the percentage
of assets funded by owner

Source of Information: Statement of Financial Position

Note: Total “Owners” only.
 Debt to Equity Ratio – a financial ratio
indicating the relative proportion of shareholder’s equity
and debt used to finance a company’s assets

Source of Information: Statement of Financial Position

 Equity to Debt Ratio – the proportion of
owner’s equity to debt

Source of Information: Statement of Financial Position

Financial Ratios
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
Profitability Ratios – how the company is
performing in generating profit and value for
shareholders

1. Gross Profit Margin

2. Operating Profit Margin
3. Net Profit Margin
Gross Profit Margin – it measures company profitability
(%). Gross profit is the amount remaining after deducting the cost of goods sold
(COGS) or direct costs of earning revenue from revenue. The gross profit margin
measures the average markup on every peso sale/ for each product.
Operating Profit Margin – computed by
deducting operating expenses from the gross profit.
Net Profit Margin or Return on
Sales– the over-all measures of profitability