Question

please write three complete and well-composed paragraphs and state which financial statement: (1) Balance Sheet or (2) Income Statement is more important to an outside investor. Explain your choice and why you think so.

You will not be assessed on your choice of financial statement (there is no correct answer to the question). But rather, your response will be assessed on how well you explain your opinion. The purpose of this question is for you to demonstrate your understanding of the uses of financial statements.

Answer 1

Investors perform fundamental analysis of the company to understand the revenue generating capacity of the company, future cashflows , quality of management and its ability to compete ,adapt and sustain the market share in the industry.

To perform this fundamental Analysis the investor require Annual Reports of the company which includes Balancesheet , Profit and Loss A/c, Notes to Accounts and Cashflow Statement.The investor throughly analysis both the Balance sheet and profit& loss A/c for better understanding of the business and income generating capacity of the company.

Investor are majorly interested in Return on Capital Employed which is a combination of income from P&l and capital from Balancesheet . It projects how much return that the company generates for the amount invested in the company. ROCE helps the investor to understand minimum or required return that can be expected from the company for their capital invested. A minimum of 12% ROCE is considered as good company to invest , the higher the percentage the greater the investor benefits.

Investors will analysis the Debt equity ratio to understand whether the company uses tax sheild benefits and able to utilized the borrowed funds effectively .Ideally a debt free company is most attractive company to invest but in order to have benefits of tax sheild a ratio of 2:1 is considered fundamentally good for a company.

In Investor perspective Wealth creation is an important element which can be studied by analysing the previous year figures with current year figures such as Earnings per share increase compared to last quater or year , Price Earning ratio of the company which will be compared to industries P/E ratio,total increase in revenue compared to last year or last quarter. All these information can only be extracted from Profit and loss A/c. So in my opinion Profit & Loss A/c plays a major role in fundamental analysis when compared to balancesheet as it helps the investor to understand the potential revenue generating capacity and its sustainablilty which forms the major part of the fundemental analysis. Even the fair value of the share is evaluated by discounting future cashflows at required rate of return and compared with market price to understand whether the share price is over valued or undervalued.