Interpretation of Financial Statements

Abstract

In this chapter we examine methods of control which do not necessarily rely on the use of budgets as described in Chapter 15. The criteria against which to judge a firm’s performance may include budgets, but may also rely on comparisons with the performance of other firms, or norms for industry as a whole.’ If managers or shareholders wish to assess whether the performance of a firm is satisfactory they will want to develop a set of criteria against which to gauge the actual results of decisions. To rely on the measurement of performance through periodic profit calculation is, as we have seen earlier, limited by the attachment to accounting concepts. However, it is possible to abstract many of the characterisitics of the firm, e.g. its profitability and liquidity, by examining patterns of relationships shown by the balance sheet and profit statement. These relationships are normally expressed for convenience in the form of ratios, which facilitate comparison between divisions of a firm, or firms within an industry, or with the economy as a whole. As explained in Sect. 14.1 this analysis provides a basis for several aspects of control, for example, the individual investor who uses information for decisions about buying or selling shares, and managers who use information to assess the performance of their firms or to make decisions within them. This chapter will analyse the uses of ratios for these various aspects of control and their limitations in the analysis of financial statements.