Chapter 32 · The Use of Financial Documents
Learn how stakeholders interpret financial information, make decisions and compare business performance through practical examples.
Learning objectives
- Explain how stakeholders use financial documents to assess the performance of a business.
- Show how accounts inform decisions about funding, costs, profitability and investment.
- Use financial data to make justified business judgments.
Using Financial Documents to Assess the Performance of a Business
Businesses produce financial documents to monitor their financial performance and make better-informed decisions. Two documents discussed in earlier chapters are the statement of comprehensive income (which summarises revenue, expenses and profit over a period) and the statement of financial position (which shows assets, liabilities and equity on a particular date). Different stakeholders use the same numbers for different purposes.
Example: O’Jar Building Supplies
O’Jar Building Supplies manufactures building materials for construction. In 2016 it wanted a new supplier of calcium silicate, but the supplier was unwilling to offer trade credit until it had inspected O’Jar’s accounts. The supplier was particularly interested in working capital (net current assets). The data below covers four years of financial results.
| Year | Current assets (€) | Current liabilities (€) | Working capital (€) |
|---|---|---|---|
| 2012 | 219,800 | 154,200 | 65,600 |
| 2013 | 233,200 | 148,600 | 84,600 |
| 2014 | 207,000 | 168,300 | 38,700 |
| 2015 | 187,300 | 193,000 | −5,700 |
Working capital fell from €65,600 in 2012 to negative €5,700 in 2015, and cash fell from €12,800 to €300. The negative working capital means current liabilities were greater than current assets by €5,700. The supplier therefore had reason to be concerned about the risk of late payment. A credit decision should also consider cash-flow forecasts, past payment records and any other funding available.
Example: Park Farm Foods
Park Farm Foods supplies chicken meat to restaurants and retailers in South Africa. Its owner, Marcus van Zyl, decided that if the business failed to earn ZAR 500,000 in profit in 2016, he would retire from farming. Cheaper imported chicken had increased competition and reduced profitability.
| Park Farm Foods (ZAR) | 2015 | 2016 |
|---|---|---|
| Revenue | 4,718,000 | 4,568,000 |
| Gross profit | 1,525,000 | 1,450,000 |
| Operating profit | 544,000 | 451,000 |
| Profit for the year | 344,000 | 201,000 |
The business made ZAR 201,000 in 2016, less than the owner’s ZAR 500,000 target. Profit also declined by ZAR 143,000 compared with 2015. On his stated rule, Marcus would choose to retire; the accounts help him make that decision rather than relying on assumptions.
Managers and Employees
Managers examine revenue, profit and expenses to judge whether the business is being run effectively. They may use results to compare branches, identify weaknesses, evaluate their own performance or assess the business against competitors. Good financial performance can also support a request for rewards or recognition.
Employees can use accounts when negotiating pay, discussing bonuses or assessing job security. Rising profits might strengthen a case for a wage increase, although the firm still needs enough cash to fund wages. Falling profits or rising debt may suggest potential employment risks.
Owners and Shareholders
Owners assess whether the business is meeting financial targets and generating a worthwhile return for the effort and funds invested. A sole trader, such as Marcus van Zyl, may use profit to decide whether to continue trading.
Shareholders in limited companies examine profits, dividends, financial growth and returns on their investment. They may compare financial ratios with those of other businesses before deciding whether to buy, hold or sell shares. Growth is attractive, but it should be assessed alongside the financial risks.
External Stakeholders
Banks and other lenders investigate whether a business can repay borrowing and interest. They review liabilities, cash, working capital and trends across several years. Suppliers examine creditworthiness before agreeing to supply goods on trade credit; the O’Jar case is an example.
Potential investors, financial analysts, insurance companies and pension funds may use published accounts to assess performance, risk and potential returns. They need to consider both the statement of comprehensive income and the statement of financial position; one strong year of sales is not necessarily proof of financial strength.
Example: Bibblington Pharmaceuticals
Bibblington Pharmaceuticals supplies drugs and medicines to South East Asian markets. Its shareholders expect a 10% return on capital employed (ROCE). They inspect the accounts each year to check whether this target has been achieved.
| Year | Revenue (US$m) | Operating profit (US$m) | ROCE |
|---|---|---|---|
| 2013 | 45.66 | 3.98 | 11.10% |
| 2014 | 47.85 | 4.12 | 11.40% |
| 2015 | 79.41 | 4.10 | 10.90% |
| 2016 | 47.11 | 3.16 | 8.30% |
The 10% ROCE target was achieved in 2013, 2014 and 2015, but not in 2016. Revenue declined sharply between 2015 and 2016, and operating profit was also lower. Even though ROCE remained positive, shareholders might be concerned by the reduction and ask management to explain it.
Using Financial Documents to Inform Decision Making
Financial documents contain quantitative information—information expressed in numbers. Managers analyse these figures to identify risks, judge the likely consequences of different actions and choose between options. Four common financial decisions are explained below.
Funding Decisions
Financial information can help a business predict when it might need additional funding. Comparing current assets with current liabilities helps managers determine whether it has sufficient working capital. If liquidity is weak, short-term funding may be needed to meet urgent bills.
For expansion, managers assess how much debt already exists, available cash and retained profit. A business with high non-current liabilities might consider raising funds through additional shares rather than taking another loan. Where substantial retained profit has accumulated, managers may instead finance growth internally. The most suitable option depends on ownership, cost and circumstances.
O’Jar’s 2015 working capital was −€5,700. Before purchasing more materials, managers might negotiate payment terms, chase overdue receivables or consider additional funding; simply reporting accounting profit would not show whether immediate bills can be paid.
Reducing Costs
The statement of comprehensive income can reveal whether spending is growing faster than revenue. Managers compare gross profit margin and operating profit margin over several periods. If gross profit margin rises but operating profit margin falls, operating expenses may be increasing relative to sales.
Managers can then investigate administration, wages, distribution and other overheads. Cost reductions should be selective: cutting employee training or product quality may save money initially but cause larger problems later.
Park Farm Foods’ operating profit fell from ZAR 544,000 to ZAR 451,000. Its administrative expenses increased from ZAR 761,000 to ZAR 769,000 and other operating expenses from ZAR 220,000 to ZAR 230,000. Managers could examine these costs while also considering the pressure created by cheaper competing imports.
Increasing Profitability
Financial accounts show whether profit margins are lower than expected or below those of competing businesses. Low gross profit margins may indicate that selling prices are too low or that cost of sales is too high. Managers could investigate alternative suppliers, reduce wastage or review prices.
If overheads absorb too much gross profit, the firm might change operating procedures or control non-essential spending. If revenue is weak, it may develop new products, promote existing products more effectively or explore new markets, including overseas markets. The aim is to improve profit sustainably, not simply to maximise this month’s sales.
Investment Decisions
Investment in new equipment, premises or products involves uncertainty. Managers can use current financial statements to check whether the business has enough cash reserves, manageable debt and adequate profitability to support the risk.
However, historical financial figures cannot guarantee that a proposed investment will succeed. Managers should also consider forecast demand, market conditions, likely costs, alternative projects and future cash flows.
A manufacturer whose accounts show strong cash balances and modest borrowing may be better placed to buy an efficient machine than one with persistent losses and little working capital. The accounts indicate its starting position, but management still needs to estimate the machine’s future return.
Check your understanding · Halfway
Try each question before opening the suggested answer.
What is the main difference between a statement of comprehensive income and a statement of financial position?
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The statement of comprehensive income records revenue, expenses and profit over an accounting period. The statement of financial position shows the business’s assets, liabilities and equity at a particular date.
Calculate O’Jar Building Supplies’ working capital in 2012 and 2015. What happened?
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2012: €219,800 − €154,200 = €65,600. 2015: €187,300 − €193,000 = −€5,700. Working capital deteriorated by €71,300, increasing concern about short-term payments.
Why might O’Jar’s potential supplier want to read the accounts before providing trade credit?
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The supplier needs to judge creditworthiness—whether O’Jar is likely to pay by the agreed date. The steep fall in cash and negative 2015 working capital indicate a greater risk of late payment.
Park Farm Foods earned ZAR 201,000 in 2016. By how much did it miss Marcus van Zyl’s target?
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ZAR 500,000 − ZAR 201,000 = ZAR 299,000. According to the owner’s stated plan, failure to meet the target would lead him to retire.
Explain one reason employees and one reason shareholders might want the same financial statements.
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Employees may assess job security or the business’s ability to afford a wage rise. Shareholders may evaluate profitability, dividend prospects or the return earned on their investment.
Did Bibblington Pharmaceuticals meet its 10% ROCE target in every year from 2013 to 2016? Explain.
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No. The target was achieved in 2013 (11.10%), 2014 (11.40%) and 2015 (10.90%), but not in 2016 (8.30%). Shareholders may investigate why returns declined.
Other Users of Financial Documents
Financial documents are not used only by owners, managers and lenders. Other groups use published or supplied accounts for economic monitoring, comparison, reporting and regulatory purposes.
Government
Governments gather business and financial information to monitor the economy, assess economic policies and provide evidence for researchers. Aggregated financial results can show how industries and businesses are performing.
Competitors
Competitors may examine publicly available company accounts to compare revenue, profits and financial strength. The information can also help a competitor assess a possible takeover or market-entry opportunity.
The Media
Television, radio, newspapers and online media report on business performance. Specialist publications, such as the Financial Times mentioned in this example, use financial information when discussing company news and economic developments.
Tax Authorities
Tax authorities may require income and other accounting details to determine the taxes a business or its owners owe. VAT and excise duties as examples. Accurate records support the required tax calculations and reporting.
Auditors
Independent accountants and registered auditors may check limited-company accounts. This checking process is called auditing; it helps users place confidence in the financial information. Specific audit requirements depend on the country and company and can change over time.
Registrar of Companies
In many countries, limited companies register with an official registrar and submit required annual accounts. These documents may then be available to the public. The exact reporting obligations vary with local law and business size.
Reporting rules may vary by country and change over time. Students should learn the roles of these users rather than assume the same legislation applies in every country today.
Large vs Small Businesses
The quantity and complexity of financial documents often differ by business size. A small owner-managed firm may focus first on basic records, annual profit and cash available to pay bills. Very small businesses may have simpler reporting obligations than larger limited companies.
A large limited company is more likely to prepare a fuller set of financial statements for managers, owners, lenders, regulators and investors. The information is used to compare departments, assess funding needs and make major investment decisions. Very small companies may have exemptions from some requirements; these are not uniform across countries or years.
| Area | Smaller business | Larger business |
|---|---|---|
| Main internal interest | Survival, cash, personal return and affordable growth | Division performance, margins, capital efficiency and funding |
| Common users | Owner, lender and key suppliers | Managers, shareholders, banks, analysts and regulators |
| Reporting | May be relatively simple, subject to applicable rules | Usually more extensive and complex |
| Business risk | One debt or loss can be particularly disruptive | May spread risk across operations, but can also have large liabilities |
End-of-chapter questions
Try each question before opening the suggested answer.
Define quantitative information and give two examples found in financial documents.
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Quantitative information is numerical information. Examples include revenue, profit, cash, current liabilities, working capital and financial ratios.
Explain two ways financial documents can help a business decide how to finance expansion.
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Financial statements show existing debts and liquidity, which help judge whether further borrowing is feasible. They also show retained profit and cash, which indicate whether internal funding may be possible. Share issues may be an alternative for eligible companies.
A firm’s gross profit margin rises but operating profit margin falls. What might this suggest?
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The proportion of revenue left after cost of sales rose, but operating overheads may have increased by even more. Managers should examine administrative and other operating expenses before deciding what to change.
Explain why financial accounts cannot guarantee the success of a new investment.
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Accounts mainly provide historical information. Future demand, prices, competition, project costs and cash flows may differ from the past, so forecasts and non-financial evidence are also needed.
Identify three non-managerial users of financial documents and explain their interests.
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For example, banks review repayment ability; suppliers assess trade-credit risk; tax authorities check taxable income and amounts owed. Shareholders, auditors, media and competitors are also valid with suitable explanation.
Why might a competitor examine another company’s published accounts?
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To compare performance, profitability and financial strength, and possibly assess a takeover opportunity. Financial accounts cannot reveal every commercial advantage or future plan.
A retailer has current assets of €120,000 and current liabilities of €70,000. One year later its current assets are €100,000 and current liabilities €85,000. Calculate the change in working capital.
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Initially, working capital = €120,000 − €70,000 = €50,000. One year later it is €100,000 − €85,000 = €15,000. Working capital fell by €35,000.
A company has revenue of €500,000 and operating profit of €60,000 in one year, followed by revenue of €480,000 and operating profit of €36,000. Calculate both operating profit margins.
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First year: €60,000 ÷ €500,000 × 100 = 12.0%. Second year: €36,000 ÷ €480,000 × 100 = 7.5%. Profitability as a proportion of sales has fallen.
A retailer’s current assets and current liabilities change from €240,000 and €120,000 to €195,000 and €130,000. Calculate both current ratios and interpret the change.
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First year: €240,000 ÷ €120,000 = 2.00:1. Second year: €195,000 ÷ €130,000 = 1.50:1. The lower ratio suggests that short-term asset cover has weakened.
Explain two management decisions a business might make after its income statement shows falling operating profit.
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It could identify and reduce controllable overheads, or review prices and its sales mix to improve contribution. Decisions should consider how savings or price changes affect product quality and demand.
A business increases annual revenue from €1.2m to €1.35m, while operating profit falls from €180,000 to €90,000 and cash falls from €95,000 to €45,000. Evaluate its overall performance.
Show suggested answer
Revenue increased by 12.5%, but operating profit fell by 50% and cash by about 52.6%. Sales growth is encouraging, yet weaker margins and less cash are warning signs. Managers should investigate costs, credit terms and cash-flow forecasts before judging the expansion a success.
Chapter 32 recap
Financial documents are useful to managers, employees, owners, shareholders, banks, suppliers, other external stakeholders and public bodies. The statement of comprehensive income helps users assess revenue, expenses and profit; the statement of financial position helps assess assets, liabilities and the strength of the financial position. Businesses use financial documents for funding, cost control, profitability and investment decisions. However, accounts mainly report past events, so a careful assessment also considers cash flow, business context and likely future conditions.
Source reference: Pearson Edexcel International GCSE Business (9–1), Chapter 32. Historical figures are included for educational illustration. IGCSE360 is an independent learning website and is not affiliated with Pearson.