Question

The three financial statements: the Income Statement, the Balance Sheet, and the Statement of Cash Flows. Please explain the advantages and disadvantages of using these statements to make financial decisions for the firm. Note what valuable information can be obtained from each statement. Think about how that information can be used to guide decisions and how that information might be misleading.  

Answer 1

ADVANTAGES OF INCOME STATEMENT:

1. Provides detailed information on revenues:The income statement provides detailed data on revenues. Besides the normal costs such as the cost of goods sold (COGS), employee expenses, operational expenses, it also accounts for additional costs like taxes applicable. Similarly, on the revenue front, it accounts not only for revenues earned from sales but also factors in for revenues gained from non operational components like interest accrued by different investments. Hence, the income statement is an ideal source for complete revenue information.
2. Database for Investor Analysis: It is an important document for investors who need detailed information before investing into any company. It provides all the data from sales to profits, operational efficiency to other non operational aspects. All this cumulatively helps investors get a clear picture of how the business is and expected to be. Thus, it is a single source to judge the condition of a company.
3. Other benefits: The income statement shows the profitability of the company over a period of time. The company can determine the major revenues it has earned. Secondly, it is significant because it is based on the matching principal and shows the expense incurred by a company to earn the revenues. From an investment perspective, shareholders of a company are interested in the net income because the dividends are paid out of the total income. Moreover, income statement also helps the companies analyze their expenses and take into account the major streams of operating revenues of the company.

DISADVANTAGES OF INCOME STATEMENT:

1. Misrepresentation of data:The income statement includes not only current revenues gained from sales but also the money due from accounts receivable which the business has not paid yet, just as it includes liabilities as expenses that have not actually been paid yet. Also, the large one-time expenses or revenues can drive the income sharply up or down from what it actually should be. This leads to misrepresentation of the success of the company
2. Other factors:The income statement helps in gauging the earnings per share and other past financial data, but it does not provide with data on the expected future growth. It does not give any indication on how the revenue generation happens. A business may be underpaying employees and overcharging customers to create its profits, practices that will eventually cause business problems but show as positives on the financial document. Any investor looking into the income statement has to have these additional factors also in mind before taking any financial decision. One needs to remember that the income statement is considered as a fiction because it is based on accrual accounting and it does not provide cash transactions. Free cash cannot be calculated through income statement

ADVANTAGE OF BALANCE SHEET

Keeping Things in Balance

The balance sheet equation shows that a company's assets equal its liabilities plus its stockholders' equity. Since this equation must always hold, any deviation from it indicates a failure of the company's accounting systems. The highly structured format of the balance sheet breaks the three major components into a series of accounts with dollar values as of a given date. As such, it is a compact, easily understood source of current information, and it shows trends when compared to previous balance sheets.

Ratios

Managers, investors, lenders and regulators take the measure of a company by calculating financial ratios using information from the balance sheet, often in conjunction with other reports such as the income statement. For example, balance sheet data is used to examine liquidity, which is the ability of the company to pay its current bills, by dividing current assets by current liabilities (the current ratio). There are dozens of balance sheet ratios that help show how a company compares to its competitors and can help detect important financial trends.

DISADVANTAGE OF BALANCE SHEET

Misstated Long-Term Assets

Long-term assets are expected to last more than one year and include items like property, plant and equipment. The balance sheet records the value of long-term assets at the price paid for them, known as the historical or book value. A disadvantage of this approach is that it ignores the current value of these assets. Depreciation reduces the value of long-term assets according to an arbitrary schedule created for tax purposes but does not necessarily reflect real wear and tear. Furthermore, the balance sheet ignores any gain in value or the money it would take to replace an asset at current prices. Book value can substantially understate long-term assets, distorting the wealth of the company.

Missing Assets

Only assets acquired by transactions are reported on the balance sheet. Therefore, it omits some very valuable assets that are not transaction-oriented and can't be expressed in monetary terms. For example, a company might have a highly valuable group of technical experts that would be hard to replace but are not reported on the balance sheet. In addition, assets developed internally, such as an online internet sales channel, can have tremendous value that the balance sheet ignores.

Advantages of Cash Flow Statement

1. It shows the actual cash position available with the company between the two balance sheet dates which funds flow and profit and loss account are unable to show and therefore it is important to make a cash flow report if you want to know about the liquidity position of the company.
2. It helps the company in making accurate projections regarding the future liquidity position of the company and hence arrange for any shortfall in money by making arrangements in advance and if there is excess than it can help the company in earning extra return out if idle funds.
3. It acts like a filter and is used by many analyst and investors to judge whether company has prepared the financial statements properly or not because if there is any discrepancy in the cash position as shown by balance sheet with cash flow statement than it means that statements are incorrect.

DisAdvantages of Cash Flow Statement

1. Since it shows only cash position, it is not possible to arrive at actual profit and loss of the company by just looking at this statement alone.
2. In isolation this is of no use and it requires other financial statements like balance sheet, profit and loss etc…, and therefore limiting its use.