Users and forces of Financial Statements Information

Learning Outcome
At the end of this topic, the learner should be able
Identify users of financial statements
Determine the need for Financial statements for various users
Identify costs associated with disclosures

2.1: Introduction

What‟s observed in financial statement is a product of a diverse set of act and is forces.

These are various parties that will add financial statements information. Those

information facilitates decisions making, monitoring of management. It‟s also used to

unrepeated contracts or agreements that improve provisions based on such information.

Parties include: - Shareholders, investors and security analysis.

Shareholders and other investors and the major recifuants of the major financial

statements. These parties range from individual with relatively ltd uses to large well

endowed institutions e.g. in services companies, banks etc. The decision made by these

parties include, not only decision on what shares to buy, retain or sell put also the timing

of the purchase or sell of these securities.

These decision will either have both investments focus and stewardships focus a better

investments focus emphasis on choosing a portfolio of securities that is contestant with

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the preferences of the investors for task, return, dividend yield etc. stewardship focus

concerns the shareholders with monitoring the behaviour of the management and

attempting to effects its behaviour of the management and attempting to effect its

behaviour in a way deemed appropriate e.g. management may have a considerable

discretion concerning the use and disposition of firms uses i.e. diverting these uses from

existing shareholders having them with only the corporate share.

2.2 Managers
A some of dividend for financial statement information by managers arise from contracts

that include provisions based on financial statements variables contractual agreements

between firms and other entities are based on financial statements information e.g. in a

join-partnership argument are firm may agree to the operating factions in order to share in

the earnings of the partnership on agreed large basis, the partnership on agreed large

basis, the partnership will care derived add for financial statements information. Other

contractual agreements involved margins, acquisitive coalition etc.

Managers will also utilize financial statements information in many other financing

investment or operating *** e.g information about debt to equity ratio is important in

deciding how much long-term debt to raise.

2.3 Employees
This can arise from survival motivational factors. Employees have rested interest in the

conformed. The statements are on important source of information about current and

potential. Employees can also demand this statement to monitor the viability of this

pension plan.

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2.4 Lenders and other suppliers
For suppliers of loan capital e.g. banks in the initial loan granting stage, financial

statements are typically on important item-indeed many banks have standard evaluation.

Banks stipulate that information relating to liquidity and profitability be considered when

determining the amount of loan, also to be considered in its nonghosted.

If the decision to grant a loan is made. The terms of that loan may contractually stipulate

that firm statement variable be an important factor in determining the nature of the

ongoing relationship. Other suppliers of raw material and gas need this information to

ascertain the credit worthiness of the organization they are doing business rich.

2.5 Customers
The relationship through the firm and its customers take the form of legal obligations

associated with guarantees and warrants. A customer will be concerned with interaction

thus parties in relation through financial institution statement disclosure.

Decision from firm

services

Market forces
Information set
available to external
factors

Regulatory forces

Decision by non-firm
information sources e.g.
brokerage hsp and industry
trade associations

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 2.5.1 Regulatory forces and the supply of financial statements
Public sector based regulatory forces usually affect the deen of the form and other

qualities. We also have private sector regulatory. In some cases specify legislation

governs the contents of financial report.

Level 1: consists of the executives, legislative and judicial branches of the government.

The executive and the legislative exerts pressure in a pro-active way while the judicial

branch exerts influences via its ruling.

Level 2: Involves governmental regulatory body such as development within treasury.

Level 3: involves private sector bodies such as accounting body and stock exchange.

Level 4: include other lobbying groups attempting to influence decision made by parties

Levels 1, 2, 3. Those groups range from e.g. financial analysts and financial executive

institutes.

Executive branch of the Legislative branch of Judicial brand of the

Le government e.g. officer government e.g. the government e.g.
ve of the president and parliament supreme court
l1 cabinet

Departments with Securities and Exchange Other government

Le treasury Commission agenda
ve
l2

Financial acting standard Institute of certitude Stock exchange market

Le board public accountants e.g. N.S.E
ve
l3

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Financial analysts Financial executives‟ Other lobbying

Level 4 federation institutions organizations
All four levels influences financial exporting move by the firm. For this reasons the

framework is best views as a joint effort than public sectors ones in level 3 and 4.

Level 1 bodies typically don‟t make standard relating to corporate financial statements

rather those bodies delegate the power to make such standard to levels 2 and 3.

2.5.2 Market forces and supply of financial statement information

The disclosures of information are likely as a result, of market forces that affect the

contents obtaining the financial statement disclosure. They include

1.Capital market forces

There are various dimensions in which firm compete with each other in the easy market.

these dimension may include:-

The instruments offered e.g. equity securities, preferred securities, loans etc

Terms of instruments offered i.e. interest rates maturity dates of instruments etc
The distribution of expected returns from each instrument

Market forces will expert pressure on firms and other capital raisers provide financial

information that relates to the foregoing factors. Firms have an obligation to stratify a set

of information that they believe they‟ll enable them raise capital on the best available

term.

In some cases these can be incentives to make overly optimistic (possibly falls or

misleading) representation in their financial statement.

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We‟ve FOUR mechanisms that exist to reduce the likelihood of such misrepresentation

in firm financial statement. They include

Reputation of the firm – firms typical make several equity on debt issues over time

and they are interested on maintaining their credibility with fin-community.

A short-gain due to a firm. Misrepresentation could prove to be very costly in

the subsequent visits in the capital market.

The reputation of the management- individual managers has vested interests in

maintaining their own credibility. Statement by managers with low credibility

is likely to be heavily doubted. In addition, the labour market for managers is

likely to penalize individuals who are not perceived to be reliable in dealing

with external parties.

Through party information certification – individual or with supplying capital to the

rd
firm often require third party to verify the in made by management. These 3

parties serve many clients and likewise has a strong interest in maintaining its

reputation with firm community.

Legal penalties- Most jurisdiction have civil or criminal penalties for attempts to

defraud external parties via the issuances of false or mis-leading financial

representation

The system of checks and balances implicit in this mechanism above helps to add the

reliability of financial statements placed in the public domain

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2. Labour market forces

Here what‟s assigned in the quality of management and the labour market has an interests

on this if left un-restricted management could make decrease that significantly reduce the

value of equity or debt component of the firm.

Managers who are unbridling to agree in the constraints placed on their behaviour or

mechanism being put in place to monitor their action may not be hired or if hired they

may be paid a relatively low salary. Labour market forces therefore can arise in from both

internal sources e.g. via changes in the marketability of the cultures of other firms and

internal sources e.g. ma changes in promotion prospects, salary etc. the mechanism

rd
available to monitor management include: Creditability of financial states and 3 party

certification of these statements.

rd
3 party certification is likely to be viewed by external labour market as increasing the

credibility of inferences drawn from fin state about the quality of management.

3. Corporate control market forces

Managers appear to value very highly their ability to control financing, investments and

operating decision the firm. Attempts by external parties to take this control often from

existing management often encounter stiff competition e.g. take over battle between

existing management and friendly suitors or fights within a coalition of existing

management and a sub-set of shareholders visa versa rather set of shareholders.

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One tactic the management can use is such battle is to release financial information that

they perceive will increase the likelihood of them retaining control.

Cost associated with disclosures

One factor that management consistently right as important in disclosure document is the

costs. The Ltd numerical information that‟s available mostly relates to estimated costs of

complying with regulation mandate. A company must prepare data that can withstand

something. In expensively prepared estimates may at times not withstand these sanitary.

Also included are the costs of verification by external auditors, incase independent

opinion is required.

1.Litigation costs

Legal suits against the form or its managers concerning released estimates are un ever

present threat in today‟s libidinous society.

In some cases this threat can operate to reduce those disclosures e.g. one argument

against voluntary disclosure of earning forecast is that they may term out to be

overly optimistic.

Investors then may use this incorrect forecast as one basis in sue management to obtain a

reimbursements to a drop in the price is unrest equity.

In other case the threats of litigation can promote correct disclosure prompt public release

of collect statements can reduce the potential losses to shareholders or reduce the

potential exposure of the firm and its management to subsequent litigation.

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2. Political costs

Governments have the power to expatriate wealth from corporation and redistribute it to

other parties. In reports present one source of such information that government can use

to choose firms or industries that will be singled out. In this quirt form many choose

accounting method that may perceive may reduce the likelihood of large profit increases

being imported in any one year. Political cost consideration can have influences the

disclosure often of the firm. Firms may disclose certain information items in they provide

evidence that the agreement used by those washing to appropriate wealth from them are

valid. Forms can also choose to aggregate items in such a way that their political costs

exposure is reduced in this light firms should have a clear distinction between two

avoidance and evasion.

3. Competitive disadvantage costs

A corruption argument presented against disclosure is the incurred when competitors uses

disclosure of their uses advantage e.g. when employees or management of company use

the information that they‟ve to involve themselves in greater investment.

Another sensitive area in this connection is information about R & D of a new product.

Firms that perceive that they have advantage over competition in this area face difficult

seen mainly new capital. Unless they provide detailed into pertaining to R & D the capital

market is less likely to support a new capital offering, yet if they provide

4. Collection and processing costs

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5. Additional constraints on managerial decision.

In summary This analysis is important to various parties with a financial stake in the

company. These include:

Shareholders – Actual owners are interested in the company‟s both short and long term

survival. For this reason they will use ratio‟s such as:

Profitability ratios – which seek to establish viability.

Dividend ratios – which seek to establish return to owners in form of dividends.

The common ratios include earning yield (E/Y), Dividend pay out ratio

(DPO), dividend yield, Price earning ratio, all of which will measure

return to owner.

Creditors (trade) – these are interested in the company‟s ability to meet their short-term

obligations as and when they fall due. For this reason they will use ratios such as:

Liquidity ratio – a qualitative measure of company‟s liquidity position measured

by acid test ratio.

Current ratio – which is a measure of company‟s quantity of current assets against

current liabilities.

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Long term lenders – These include finances through loans, mortgages and debenture

holders. These have both short and long term interest in the company and its

ability to pay not only interest on debt but also principal as and when it falls due.

These parties are interested in the following:

Liquidity ratios – used to assess short-term liability to meet current

obligations.

Profitability ratios – used to ascertain whether the company can pay its principal

back.

Gearing ratio – used to gauge the company‟s risk in the investment.

Investment coverage ratio – shows the company‟s safety as regards the payment

of interest to the lenders of the debt.

Directors and management of company – They will therefore be interest in:

Efficiency of the company in generating profits.

The company‟s viability from the investor‟s point of view and the company‟s

ability to generate sufficient returns to investors.

Gearing ratio to gauge the safety and risk associated with the company.

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Potential investors – these parties are interested in a company in total both on short and

long term basis in particular the company‟s ability to generate acceptable return

on their money.

Therefore, they will use:

Dividend ratios

Return ratios

Gearing ratios

Government – The Government is interested mostly in utility companies (e.g. KPLC,

KPTC) and those that will provide public services – in this case the government

will be interested in their survival and thus ability to provide those services. It

may be interested in taxation derived from these companies which is used for

development. Government may also be interested in employment level and as

such it will use those ratios that can enable it to achieve such objectives of

particular importance are:

Profitability ratios

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 Return ratios

Competitors – These are interested in the company‟s performance from the market share

point of view and will use the ratios that enable them to ascertain company‟s

competitive strength e.g. profitability ratios, sales and returns ratio etc.

General public – Customers and potential customers – These are interested in the ability

of the company to provide good services both in the short and long run.

To gauge the company‟s ability to provide goods and services on short and long

term basis. We have:

Returns ratio

Sales ratio

Revision Questions
Question One
Outline four limitations of the use of ratios as a basis of financial analysis. (4
marks)
What is the need for Financial statements for various users
Explain the costs associated with disclosures

Three years ago, Mrs. Rehema Waziri was retrenched from the Civil Service. She
invested substantially all her terminal benefits in the shares of ABC Ltd., a
company quoted on the stock exchange. The dividend payments from this
investment makes up a significant position of Mrs Waziri‟s income. She was
alarmed when ABC Ltd. dropped its year 2001 dividend to Sh.1.25 per share from
Sh.1.75 per share which it had paid in the previous two years.Mrs Waziri has
approached you for advice and you have gathered the information given below
regarding the financial condition of ABC Ltd. and the finance sector as a whole.

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ABC Ltd. Balance Sheets as at 31 October
1999 2000 2001

Sh.’000’ Sh.’000’ Sh.’000’

Cash 15,250 14,400 8,000
Accounts receivable 80,320 87,800 134,400
Inventory 98,600 158,800 254,000
Total current assets 194,170 261,000 396,400
Land and buildings 25,230 27,600 25,000
Machinery 33,800 36,400 30,600
Other fixed assets 14,920 18,200 16,400
Total assets 268,120 343,200 468,400
Accounts and notes payable 34,220 73,760 135,848

Accruals 15,700 34,000 67,000

Total current liabilities 49,920 107,760 202,848
Long term debt 60,850 60,858 81,720
Ordinary share capital 115,000 115,000 115,000
Retained earnings 42,350 59,582 68,832
268,120 343,200 468,400
ABC Ltd. Income Statements for the year ending 31 October
1999 2000 2001

Sh.’000’ Sh.’000’ Sh.’000’

Sales (all on credit) 827,000 858,000 890,000
Cost of sales (661,600) (710,000) (712,000)
Gross profit 165,400 148,000 178,000
General administrative and selling expenses (63,600) (47,264) (51,200)
Other operating expenses (25,400) (31,800) (38,200)
Earnings before interest and tax (EBIT) 76,400 68,936 88,600
Interest expense (12,800) (26,800) (63,600)
Net income before taxes 63,600 42,136 25,000
Taxes (25,400) (16,854) (10,000)
Net income 38,200 25,282 15,000
Number of shares issued 4,600,000 4,600,000 4,600,000

Per share data:

Earnings per share (EPS) Sh. 8.30 Sh. 5.50 Sh. 3.26
Dividend per share Sh. 1.75 Sh. 1.75 Sh. 1.25
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Market price (average) Sh.48.90 Sh.25.50 Sh.13.25
Industry Financial Ratios

(2001)
Quick ratio 1.0
Current ratio 2.7
Inventory turnover 7 times
Average collection period 32 days
Fixed asset turnover 13.0 times
Total assets turnover 2.6 times
c)
Industry Financial rations
Net income to net worth 1.8%
Net profit margin on sales 3.5%
Price-Earnings (P/E) ratio 6 times
Debt/Equity ratio 50%

Notes:
Industry ratios have been roughly constant for the past four years.
Inventory turnover, total assets turnover and fixed assets turnover are based on the year-
end balance sheet figures.

Required:
The financial ratios for ABC Ltd for the past three years corresponding to
industry ratios given above. (10 marks)

Arrange the ratios calculated in (a) above in columnar form and summarise the strengths
and weaknesses revealed by these ratios based on:
(i) Trends in the firm‟s ratios (6 marks)
(ii) Comparison with industry averages. (6 marks)

(The summary should focus on the liquidity, profitability and turnover ratios).
(Total: 22 marks)

References
The Analysis and Use of Financial Statements (3rd edition) by White, Sondi &
Fried (Wiley 2003)

Financial Reporting and Analysis (4th edition) by Revsine, Collins, Johnson, and

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Mittelstaedt (McGraw-Hill Irwin 2009)

Financial Statement Analysis & Valuation (2nd edition) by Easton, McAnally,

Fairfield, and Zhang (Cambridge Business Publishers 2009)

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