What are the Objectives of Financial Statements?

Explanation of Financial Statement Objectives / Purposes

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#1 – Past Performance and Current Position Assessment

The primary objective is to depict past performance. This is because the organization’s future performance is dependent on past performance. On the other hand, the other represents the current position where the business stands in the present scenario. For example, it may show the types of assetsTypes Of AssetsAssets are the resources owned by individuals, companies, or governments expected to generate future cash flows over a long period. There are broadly three types of asset distribution: 1. Based on convertibility (current and non-current assets), 2. Physical existence (tangible and intangible assets), 3. Usage (operating and non-operating assets)read more owned by a business and the li­abilities due to a business entity.

It also explains the cash position and the mix of debt and equity available to the organization.

An investor or creditor is always keenly interested in the trend of sales, net income, expenses, cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, and the organization’s return on investment. These trends are beneficial for judging management’s past performance and thus serve as possible indicators of the entity’s future performance. Assessment of Past Performance and Current Position is very crucial for financial transparency required by various decision-makers.

#2 – Prediction of Net Income and Judging the Growth

The objective of the financial statement lies in predicting the earning prospects of net income and judging the business’s growth.

  • The financial statement helps in planning and forecasting. Financial statements help the management adopt an appropriate business policy by requiring comparisons among various peer organizations. It helps in forecasting and preparing budgets by providing information regarding the strengths and weaknesses of the business.Thus the importance of financial statements to management is that it helps communicate with different parties about their financial position. The CFO refers to financial reports to make dividend-related decisions. He would look at the profits made, the debts to be paid off, the provisions made for reserves, and decide the dividend to be distributed.

A growth trend can be concluded by comparing data from two or more years of business entity. For example, if there is an increase in sales with increased profits, it can be concluded that the business state is healthy.

While comparing investment alternatives, investors are considerate of the risk or uncertainty associated with the business’s expected return.

#3 – Prediction of the Bankruptcy of a Business Entity and another Failure

It helps keep track of the solvency of the business. It helps in predicting the bankruptcy and failure probability of business enterprises. The capacity of the entity to repay its short and long term liabilitiesLong Term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). read more must always be known.

Both managers and investors can take preventive measures to avoid or minimize losses to maintain solvency.  For example, corporate management can bring changes in operating policy, financial structureFinancial StructureThe financial structure refers to the sources of capital and the proportion of financing that comes from short term liabilities, short term debt, long term debt, and equity to fund the company’s long term and short term working capital requirements.read more, or other required changes that can be incorporated.

#4 – Help Stakeholders and other users to make Economic Decisions

It provides essential information required by stakeholders to take various economic decisions like the one about the financial position of the enterprise.

  • Like banks and other lending companies, financial institutions use it to make loan decisions or other credit decisions. It helps to decide whether to grant working capital, extend debts such as long-term loans or debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more to finance expansion, and other expenditures or not. If yes, a financial statement helps determine the credit risk associated, deciding terms for the lending and conditions of loan like collateral, interest rate, and maturity date. Thus, creditors use financial reports widely to assess the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the organization.Prospective investors use financial reports to assess the viability of investing in a business. Financial analysisFinancial AnalysisFinancial analysis is an analysis of finance-related projects/activities, company’s financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company’s results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities.read more is often used by investors and is prepared by professionals like financial analysts. Thus the importance of the financial statement is that it helps them make investment decisions.

Conclusion

Financial statements are a critical factor in ensuring that the actual financial picture of the business is presented to management and external stakeholders. It opens a window for known and educated decision-making and strategic planning for stakeholders. Still, financial statements also aim to mitigate errors that may arise due to discrepancies in numbers in various financial statements.

Understanding the basic financial statementsBasic Financial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more is a necessary step toward successfully managing an enterprise.

Also, accurate financial statements induce trust in the company. Therefore, building trust is also a very crucial objective of financial statements.

This article is a guide to the Objectives of Financial Statements. Here we provide the list of top 4 objectives, including performance assessment, forecasting, bankruptcy predictions, etc. You can learn more about accounting from the following articles –

  • 5 Limitations for Analysis of Financial StatementCredit Risk FormulaTypes of Financial AnalysisComponents of Financial Statements