Users and Needs of Financial Statements
Who Cares About Financial Statements?
Imagine you're standing outside a giant glass building with "ABC Corporation" written on it. From the street, you can see people working, lights on, maybe some fancy furniture. But here's the question: Is this company making money or losing it? Is it safe to lend them cash? Should you buy shares in it? Would you want to work there?
You can't tell just by looking. That's where financial statements come in. They're like the company's report card, health check-up, and diary all rolled into one. But who actually reads these reports? And what do they want to find out?
This is what we're diving into today: the users of financial statements and what they need from them. Think of this as learning who's sitting in the audience when a company presents its financial story, and what each person in that audience is hoping to hear.
What Exactly Are Financial Statements?
Before we meet the users, let's quickly understand what we're talking about. Financial statements are formal records that show the financial activities and position of a business. The main ones include:
- Statement of Financial Position (also called the Balance Sheet) - shows what the company owns and owes at a specific point in time
- Statement of Profit or Loss (also called the Income Statement) - shows whether the company made or lost money over a period
- Statement of Cash Flows - tracks actual cash coming in and going out
- Statement of Changes in Equity - shows how the owners' stake in the business has changed
These documents are prepared following strict rules and standards, and they're meant to give an honest, clear picture of how the business is doing financially.
Why Do We Even Need Users? Can't Companies Just Keep Their Numbers Private?
Here's a surprising fact: most large companies are legally required to publish their financial statements. Why? Because these companies don't operate in a vacuum. They take money from investors, borrow from banks, employ thousands of people, sell to customers, and affect entire communities. All these groups have a legitimate interest in knowing whether the company is healthy or heading for trouble.
Think of it this way: if you lend your friend £1,000, you'd want to know if they have a job and can pay you back, right? Financial statements do the same thing, but for much bigger amounts and many more people.
The Two Big Categories of Users
Users of financial statements fall into two main camps:
- Internal users - people inside the company
- External users - people outside the company
Let's explore both, but we'll spend most of our time on external users because they're the primary audience for published financial statements.
Internal Users: The People Inside the Building
Management is the main internal user group. These are the directors, department heads, and decision-makers running the company day-to-day. They need financial information to:
- Make strategic decisions (Should we launch a new product? Close a factory?)
- Monitor performance (Are sales up or down? Are costs under control?)
- Plan budgets and forecasts
- Evaluate different departments or projects
Here's the thing, though: management has access to much more detailed financial information than what appears in published financial statements. They can see daily sales figures, product-by-product profitability, department budgets, and more. The published statements are actually a summary that's shared with the outside world.
Employees might also be considered internal users, though they typically don't have the same access as management. They're interested in the company's stability (Will I still have a job next year?) and profitability (Can the company afford pay raises or bonuses?).
External Users: The Real Audience for Published Financial Statements
This is where things get interesting. External users don't have inside access to the company, so they rely heavily on published financial statements. Each group has different questions they're trying to answer. Let's meet them one by one.
1. Existing and Potential Investors (Shareholders)
Who they are: People who own shares in the company or are thinking about buying shares.
What they want to know:
- Is this company profitable?
- Will the value of my shares go up?
- Will I receive dividends (a share of the profits)?
- Is this investment risky?
- How does this company compare to its competitors?
Real-world example: When Tesla publishes its financial statements each quarter, millions of investors and potential investors scrutinize them. In 2020, Tesla's share price soared partly because the company finally showed consistent profitability after years of losses. Investors who read those financial statements and believed in Tesla's future made substantial returns.
Key concern: Investors are residual claimants - they get paid after everyone else (employees, suppliers, lenders). So they're very interested in the company's long-term viability and growth potential, not just today's numbers.
2. Lenders and Creditors
Who they are: Banks, bondholders, suppliers offering credit, and anyone who has lent money to the company or is considering doing so.
What they want to know:
- Can this company repay what it owes?
- Does it have enough cash and assets to cover its debts?
- Is the company taking on too much debt?
- What's the timing of cash flows - when will money come in?
Real-world example: When Lehman Brothers collapsed in 2008, triggering the global financial crisis, many creditors who had lent money to the bank lost billions. Had they analyzed Lehman's financial statements more carefully, they might have noticed warning signs: extremely high levels of debt, risky assets, and poor liquidity (not enough cash to meet short-term obligations).
Key concern: Unlike investors who want growth and high returns, lenders are primarily focused on security and repayment. They're asking, "Will I get my money back?" not "Will this company double in size?"
Lenders often look at specific ratios, such as:
- Current ratio - Can the company pay its bills due within the next year?
- Debt-to-equity ratio - Is the company too heavily financed by borrowing?
- Interest coverage ratio - Can the company comfortably afford its interest payments?
3. Suppliers and Trade Creditors
Who they are: Companies or individuals who sell goods or services to the business on credit (meaning they deliver first and get paid later).
What they want to know:
- Will this company pay its invoices on time?
- Is it financially stable enough to continue as a customer?
- Should we extend more credit or demand cash upfront?
Real-world example: When Carillion, a major UK construction company, went into liquidation in 2018, it owed approximately £2 billion to suppliers and subcontractors. Many small businesses that had supplied materials or services were never paid, and some went bankrupt themselves. Suppliers who had analyzed Carillion's deteriorating financial statements might have insisted on cash payment or stopped supplying altogether.
Key concern: Suppliers are typically looking at short-term financial health - can the company pay within 30, 60, or 90 days? They care about cash flow and current assets (assets that can be quickly converted to cash).
4. Customers
Who they are: People or businesses that buy the company's products or services, especially those entering long-term relationships.
What they want to know:
- Will this company still be around to honor warranties or provide ongoing support?
- Can it continue to supply the products I depend on?
- Is it investing in research and development for future products?
Real-world example: If you're an airline considering buying aircraft from Boeing or Airbus, you're making a decision that will affect your operations for 20-30 years. You'll examine the manufacturer's financial statements to ensure they're financially stable, will remain in business, and can provide parts and service for decades.
Key concern: Customers care about continuity and reliability. For major purchases or long-term contracts, they need confidence that the company won't disappear.
5. Employees and Trade Unions
Who they are: Current employees, potential employees, and the unions representing workers.
What they want to know:
- Is my job secure?
- Can the company afford pay raises or bonuses?
- Is the pension scheme properly funded?
- Is the company making enough profit to share some with workers?
- How does our pay compare to the company's profitability?
Real-world example: In 2020, during the COVID-19 pandemic, many companies published financial statements showing severe losses. Employees at airlines, retail chains, and hospitality companies examined these statements to understand why redundancies (layoffs) were happening and whether their employers might survive.
Key concern: Employees are interested in both profitability (which affects bonuses and raises) and stability (which affects job security). Trade unions use financial statements during wage negotiations to argue for fair compensation based on company performance.
6. Government and Regulatory Agencies
Who they are: Tax authorities, statistical agencies, regulatory bodies, and government departments.
What they want to know:
- Tax authorities: How much profit did the company make, so we know how much tax is due?
- Statistical agencies: What's happening in different sectors of the economy?
- Regulators: Is the company complying with financial regulations? (This is especially important for banks, insurance companies, and public utilities.)
- Competition authorities: Is a company becoming too dominant or abusing market power?
Real-world example: In 2016, the European Commission ruled that Apple had received illegal tax benefits from Ireland, based on analysis of financial arrangements revealed through financial disclosures. Apple was ordered to pay €13 billion in back taxes.
Key concern: Governments need accurate financial information to collect taxes, compile economic statistics, and enforce regulations. They're not typically concerned about investment returns, but about compliance and the broader economic picture.
7. The Public and Special Interest Groups
Who they are: Local communities, environmental groups, consumer organizations, journalists, researchers, and concerned citizens.
What they want to know:
- How many jobs does this company provide in our region?
- Is the company profitable enough to continue operating our local factory?
- What is the company spending on environmental protection or corporate social responsibility?
- Are executive salaries excessive compared to company performance?
- Is the company being transparent and honest?
Real-world example: When BP suffered the Deepwater Horizon oil spill in 2010, environmental groups and the public scrutinized BP's financial statements to see how much money the company had set aside for cleanup costs and compensation. The financial impact (over $60 billion in total costs) was tracked through subsequent annual reports.
Key concern: Public interest groups care about accountability, transparency, and social responsibility. They want to ensure companies are good corporate citizens, not just profitable enterprises.
8. Competitors and Business Analysts
Who they are: Rival companies, industry analysts, investment researchers, and business consultants.
What they want to know:
- Competitors: How are our rivals performing? What are their strategies? Where are they investing?
- Analysts: What are the trends in this industry? Which companies are outperforming or underperforming?
- What are the profit margins, growth rates, and key performance indicators?
Real-world example: When Apple releases its financial results, Samsung immediately analyzes them to understand Apple's market share, product mix, and profitability. Similarly, when McDonald's reports strong growth in a particular region, Burger King and other competitors study the data to understand changing consumer preferences and competitive dynamics.
Key concern: Competitors want to benchmark their performance and identify opportunities or threats. Analysts want to understand industry trends and make informed recommendations to clients.
What Information Do These Users Need?
Now that we know who the users are, let's talk about what they actually need from financial statements. Despite their different perspectives, most users share some common information needs:
1. Information About Financial Position
This answers the question: What does the company own, and what does it owe, right now?
Users need to see:
- Assets - what the company owns (cash, buildings, equipment, inventory, money owed by customers)
- Liabilities - what the company owes (loans, money owed to suppliers, taxes due)
- Equity - the owners' stake in the business (essentially, assets minus liabilities)
This information comes from the Statement of Financial Position. It's like a snapshot of the company's financial health at a specific moment in time.
Why it matters: Investors want to know if the company has valuable assets. Lenders want to see if there are sufficient assets to repay debts. Suppliers want to know if the company can pay its bills.
2. Information About Financial Performance
This answers the question: Did the company make or lose money over the past period?
Users need to see:
- Revenue (or sales) - money earned from selling goods or services
- Expenses - costs incurred to generate that revenue
- Profit or loss - the difference between revenue and expenses
This information comes from the Statement of Profit or Loss. It covers a period of time (usually a year or a quarter).
Why it matters: Profitability is a key indicator of success. Investors want to see growing profits. Employees want to know if the company can afford bonuses. Governments want to calculate taxes. Everyone wants to know if the business model actually works.
3. Information About Cash Flows
This answers the question: Where did cash come from, and where did it go?
Here's something many beginners find surprising: profit and cash are not the same thing. A company can be profitable on paper but run out of cash and go bankrupt (this is called insolvency).
The Statement of Cash Flows shows:
- Cash from operating activities - day-to-day business (selling products, paying suppliers)
- Cash from investing activities - buying or selling long-term assets (equipment, property)
- Cash from financing activities - borrowing, repaying loans, issuing shares, paying dividends
Why it matters: Cash is the lifeblood of business. Without it, you can't pay employees, suppliers, or rent, no matter how profitable you look on paper. Lenders especially care about cash flow because debt is repaid with cash, not profit.
4. Information About Changes in Financial Position
This answers: How has the company's financial position changed over time?
Users want to see trends:
- Is revenue growing or shrinking?
- Are profit margins improving or deteriorating?
- Is debt increasing or decreasing?
- Are assets being built up or sold off?
Most users will compare multiple years' financial statements to spot patterns and trends.
5. Qualitative Information and Context
Numbers alone don't tell the whole story. Users also need:
- Accounting policies - What methods and assumptions were used? (Different companies might account for similar transactions differently.)
- Notes to the financial statements - detailed explanations and breakdowns
- Management commentary - explanation of results, future plans, risks
- Auditor's report - independent verification that the numbers are reliable
Real-world example: During the 2008 financial crisis, it emerged that many banks had complex financial instruments (like derivatives) that were difficult to value and poorly explained in financial statements. When these assets suddenly lost value, many users (including investors and regulators) were caught off guard because they hadn't fully understood what was buried in the notes to the accounts.
The Objectives of Financial Reporting: What Should Financial Statements Achieve?
Given all these different users with different needs, what should financial statements actually do? The answer comes from accounting standard-setters who have developed a conceptual framework - essentially, the rulebook for financial reporting.
The primary objective is this:
To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.
Let's break that down:
- "Financial information" - numbers and explanations about money, assets, debts, profits, etc.
- "About the reporting entity" - the company or organization producing the statements
- "Useful to investors, lenders, and other creditors" - these are considered the primary users
- "In making decisions about providing resources" - should I invest? Should I lend? How much? Under what terms?
Why Are Investors, Lenders, and Creditors the Primary Users?
You might wonder: what about employees, customers, the government, and everyone else we discussed? Here's the logic:
Investors, lenders, and creditors are the groups who provide financial resources (money) to the entity, and they cannot demand information - they must rely on published financial statements. Information that meets their needs will generally also meet most of the needs of other users.
For example:
- Employees can use the same profitability information that investors use
- Suppliers can use the same liquidity information that lenders use
- Governments have legal power to demand additional specific information if needed
So by focusing on these primary users, financial statements serve a broad audience.
What Makes Financial Information Useful?
For financial information to actually help users make decisions, it must have certain qualities. Think of these as the "ingredients" of useful financial reporting:
Fundamental Qualitative Characteristics
1. Relevance
Information is relevant if it's capable of making a difference to the decisions users make. It should have:
- Predictive value - helps users predict future outcomes
- Confirmatory value - helps users confirm or correct previous expectations
Example: If you're deciding whether to invest in a retail company, knowing its revenue and profit trends over the past five years is relevant. Knowing the CEO's favorite color is not.
2. Faithful Representation
Information must faithfully represent what it claims to represent. It should be:
- Complete - includes all necessary information
- Neutral - unbiased, not slanted to make the company look better or worse than it really is
- Free from error - as accurate as possible (though some estimates are necessary)
Example: If a company claims to have £1 million in cash, the actual bank balance should support that. If the company is facing a lawsuit that could cost £5 million, that risk should be mentioned, not hidden.
Enhancing Qualitative Characteristics
These make relevant and faithfully represented information even more useful:
1. Comparability
Users should be able to compare:
- The same company over different time periods
- Different companies in the same period
This is why we have accounting standards - they ensure companies follow similar rules, making comparisons meaningful.
2. Verifiability
Different knowledgeable and independent observers should be able to reach consensus that the information is faithfully represented. This is partly why companies hire external auditors - to verify the numbers.
3. Timeliness
Information should be available to users in time to influence their decisions. Year-old information about cash flow isn't much help if you're deciding whether to extend credit today.
4. Understandability
Information should be presented clearly and concisely. Of course, some business transactions are inherently complex, but the financial statements shouldn't make things more complicated than necessary.
Stewardship: Another Important Purpose
There's another crucial purpose of financial reporting beyond helping users make decisions: stewardship or accountability.
Stewardship means showing how management has looked after the resources entrusted to them. Remember:
- Shareholders give money to managers to run the business
- Lenders trust managers to use borrowed funds wisely
- Stakeholders rely on managers to run the company responsibly
Financial statements allow these groups to assess whether managers have done a good job. Have they grown the business? Wasted money? Taken excessive risks? Managed assets efficiently?
Real-world example: When Elon Musk's compensation package at Tesla was examined through the company's financial statements, shareholders could see it was potentially worth billions of dollars, tied to specific performance targets. This allowed them to vote on whether such compensation was appropriate stewardship of company resources. (The package was approved, but only after much debate.)
Limitations of Financial Statements: What They Can't Tell You
Before we wrap up, it's crucial to understand that financial statements, while valuable, have limitations:
1. Historical Nature
Financial statements primarily report what has already happened. They don't predict the future, though users try to infer future performance from past trends.
2. Use of Estimates and Judgments
Many figures aren't precise measurements. For example:
- How much will old inventory sell for?
- How many years will equipment last?
- Will customers actually pay their bills?
These require estimates, and different companies (or even different accountants) might estimate differently.
3. Not Everything Can Be Measured in Money
Financial statements don't capture:
- Employee morale and talent
- Brand reputation and customer loyalty
- Quality of management
- Innovation and intellectual capital
- Relationships with suppliers and customers
These intangible assets can be hugely valuable but often don't appear on the balance sheet unless they were purchased.
Real-world example: When Facebook bought WhatsApp for $19 billion in 2014, WhatsApp's balance sheet showed very little in terms of tangible assets. What Facebook was really buying was WhatsApp's user base, technology, and brand - intangibles that didn't appear at full value in traditional financial statements.
4. General Purpose, Not Tailored
Financial statements are general purpose - designed to meet the common needs of a broad range of users. They can't meet every specialized need of every user perfectly.
5. Focus on the Entity
Financial statements report on the company as a whole, not specific divisions, products, or regions (though notes might provide some breakdown).
Key Terms Recap
- Financial Statements - formal records showing a company's financial activities and position, including the statement of financial position, statement of profit or loss, statement of cash flows, and statement of changes in equity
- Internal Users - people inside the company who use financial information, primarily management and employees
- External Users - people outside the company who rely on published financial statements, including investors, lenders, suppliers, customers, government, and the public
- Investors (Shareholders) - people who own or are considering buying shares in a company; interested in profitability, growth, and dividends
- Lenders and Creditors - banks, bondholders, and others who have lent money to the company; focused on security and ability to repay
- Suppliers - companies or individuals selling goods or services on credit to the business; concerned with short-term financial health and payment ability
- Primary Users - investors, lenders, and other creditors; the main audience that financial statements are designed to serve
- Relevance - the quality of information that makes it capable of influencing user decisions; includes predictive and confirmatory value
- Faithful Representation - information accurately represents what it claims to represent; should be complete, neutral, and free from material error
- Comparability - the quality that allows users to compare a company's financial information across time periods or with other companies
- Verifiability - the quality that allows independent observers to verify that information is faithfully represented
- Timeliness - information being available in time to influence decisions
- Understandability - information presented clearly and concisely so users can comprehend it
- Stewardship - the responsibility of management to look after resources entrusted to them; financial statements help assess how well this duty has been performed
- Statement of Financial Position (Balance Sheet) - shows assets, liabilities, and equity at a specific point in time
- Statement of Profit or Loss (Income Statement) - shows revenue, expenses, and profit or loss over a period
- Statement of Cash Flows - shows cash inflows and outflows from operating, investing, and financing activities
- Liquidity - the ability to meet short-term obligations; the availability of cash or assets easily converted to cash
- Solvency - the ability to meet long-term obligations; having assets exceed liabilities
- General Purpose Financial Statements - statements designed to meet the common information needs of a wide range of users, not tailored to any specific group
Common Mistakes and Misconceptions
- Mistake: Thinking only investors read financial statements
Reality: Many different user groups rely on financial statements, each with their own perspective and concerns. Lenders, suppliers, employees, government, and others all have legitimate interests. - Mistake: Believing that profit equals cash
Reality: A company can show profit on the statement of profit or loss but have little cash (for example, if it has made sales but hasn't yet collected payment). This is why the statement of cash flows is crucial. - Mistake: Assuming all users want the same information
Reality: Different users have different priorities. Investors care about growth and returns; lenders care about security and repayment; employees care about stability and compensation potential. - Mistake: Thinking financial statements tell you everything about a company
Reality: Financial statements have limitations. They're historical, use estimates, can't measure everything (like employee skill or brand value), and are general purpose rather than tailored to specific decisions. - Mistake: Believing that financial statements are purely objective facts
Reality: While audited and regulated, financial statements involve significant judgment and estimation (for example, estimating useful life of equipment, valuing inventory, or assessing whether debts will be collected). - Mistake: Confusing the primary objective with the only objective
Reality: While helping investors, lenders, and creditors make decisions is the primary objective, financial statements also serve the stewardship function - showing how management has looked after resources. - Mistake: Thinking that management and investors use exactly the same financial information
Reality: Management has access to much more detailed, frequent, and specific financial data than appears in published statements. External users rely on the summarized, periodic published reports.
Summary
- Financial statements are formal records that communicate a company's financial activities and position to a wide audience who cannot access internal information directly.
- Users of financial statements fall into two broad categories: internal users (primarily management) and external users (investors, lenders, suppliers, customers, employees, government, the public, and competitors).
- The primary users are investors, lenders, and other creditors because they provide financial resources to the company and cannot demand information - they must rely on published statements. Information meeting their needs generally serves other users too.
- Different user groups have different information needs: investors focus on profitability and growth; lenders focus on repayment ability and security; suppliers focus on short-term liquidity; employees focus on stability and performance; government focuses on tax and compliance.
- The primary objective of financial reporting is to provide useful financial information to help existing and potential investors, lenders, and creditors make decisions about providing resources to the entity.
- Financial statements also serve a stewardship function, allowing stakeholders to assess how well management has looked after the resources entrusted to them.
- Useful financial information must be relevant and faithfully represented (fundamental characteristics), and is enhanced when it is comparable, verifiable, timely, and understandable.
- Users need information about four main areas: financial position (what is owned and owed), financial performance (profit or loss), cash flows (cash movements), and changes in financial position over time.
- Financial statements have important limitations: they're historical, use estimates and judgments, can't measure everything important (especially intangibles), are general purpose rather than tailored, and focus on the entity as a whole.
- Understanding who uses financial statements and why is fundamental to understanding what financial reporting is trying to achieve and how accounting standards are developed to meet those needs.
Practice Questions
Question 1: Recall
List five different external user groups of financial statements and briefly explain what each group is primarily interested in learning from the statements.
Question 2: Application
A small business owner argues, "My financial statements are my private business. Why should I have to publish them for everyone to see?" How would you respond, explaining the rationale for financial reporting to external users?
Question 3: Analysis
Company A reports profit of £500,000 for the year, but its statement of cash flows shows a cash decrease of £200,000. Company B reports profit of £300,000 and a cash increase of £400,000. From the perspective of a bank considering lending money to one of these companies, which situation is more concerning and why?
Question 4: Understanding Concepts
Explain the difference between the primary users of financial statements and other users. Why are investors, lenders, and creditors considered primary users, and does this mean other users are less important?
Question 5: Application and Evaluation
A company's financial statements show that it is highly profitable, with growing revenue year after year. However, nearly all of its assets are intangible (brand value, patents, customer relationships) with very few tangible assets like property or equipment.
(a) From a lender's perspective, what concern might this raise?
(b) From an investor's perspective, might this be viewed differently? Explain.
(c) What does this tell you about the limitations of financial statements?
Question 6: Evaluation
Explain how the concept of stewardship relates to financial reporting. Provide a real or realistic example of how financial statements help stakeholders assess whether management has been a good steward of company resources.
Question 7: Analysis
The fundamental qualitative characteristics of useful financial information are relevance and faithful representation. Choose one of these and explain why financial information that lacks this characteristic would fail to meet users' needs. Give a specific example to support your answer.
