The Purpose of Financial Statements

The purpose of externally reported financial statements is to provide useful financial information about a business to its investors and lenders and render an accounting to its sources of capital. Others may be interested in the financial affairs of a business—for example, its employees and other creditors. The primary audience of financial statements is the owner-investors in a business and its lenders. Financial reporting standards and generally accepted accounting principles (GAAP) have been developed with this primary audience in mind.

The dissemination of financial information by publicly-owned businesses, those whose capital stock shares and other securities are traded in public markets, is governed by federal law, which is enforced mainly by the Securities & Exchange Commission (SEC). The New York Stock Exchange, NASDAQ, and other securities markets also enforce many rules and regulations regarding the release and communication of financial information by companies whose securities are traded on their markets.

For instance, a business cannot selectively release information to some stockholders or lenders but not to others, nor can a business tip off some of them before informing the others. The laws and accepted practices of financial reporting are designed to ensure that all stockholders and lenders have equal access to a company's financial information and financial statements.

A company's financial statements may not be the first source of information about its profit performance. Public corporations put out press releases consisting of short summaries of their most recent earnings results. These press releases precede mailing the company's latest financial report to its stockholders and lenders. Privately owned or nonpublic businesses do not usually send out a letter to their owners and lenders in advance of their financial statements, although they could, of course.

This chapter examines what stockholders and lenders do with the financial statements once they get them. The chapter centers on the annual set of financial statements, which is the most complete. (Quarterly financial reports are abbreviated versions of the annual reports.) In particular, this chapter focuses on certain ratios that are useful to take the measure of a company's situation and achievements, and to pinpoint potential trouble spots.

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