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The main purpose of studying finance is to gain an understanding of the financial performance of a company, corporation or industry. By looking at a company's financial performance, decisions can be made about many things by many different players. Corporations are rated by different agencies that examine financial records and potential for growth. Fitch ratings are a good example of this. My employer has an A++ Fitch rating. This high rating allows a non-profit company to borrow money at lower interest rates. In a publicly held company, which is one that has shareholders, the main concern is to keep the shareholders happy. Shareholders infuse corporations they believe in (usually based on financial performance) with capital. When a company is considered a poor financial risk, the public will not be in a hurry to buy its stock.
So who is affected by finance? Shareholders, as mentioned previously, are the focus in publicly traded companies. They are not the only people who think about financials, however. The CEO, CFO and any other "C" position have accountability to report to the board about the financial performance of the company. Management is responsible for creating and maintaining both capital and operational budgets. Employees are required to maintain certain standards of productivity. Customers are affected by finances as well. Consider gas prices, and how increased costs in production are passed on to the consumer.
When looking at a company's finances, there are essentially four items to consider: the income statement, the price earnings ratio, the balance sheet, and the statement of cash flows, (Block, 2005). The income statement is a tool used to measure profitability over a given period of time, i.e. quarterly, annual. The income statement evaluates the cost of producing goods or services and the money that was made as a result of selling those goods/services. Gross profit and net earnings are two key features to look at.
The price earnings ratio measures the relative valuation of earnings, (Block, 2005). This is a way of looking at how your company's stock earnings compare to other companies both within and outside your industry. This ratio is affected by many variables like marketability, sales growth, and the debt-equity structure of a company.
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The statement of cash flows is used to emphasize the critical nature of cash flow with respect to a company's operations, (Block, 2005). Like individuals, corporations have bills to pay. When an individual applies for a loan, the bank will look at a figure called the debt to income ratio. This ratio will tell the lender if the individual will be able to make their mortgage payments, car payments, utilities, etc. based on their current income. This is analogous to a company's cash flow statement.
Using this basic information, financial analysts can perform more detailed research on the numbers. Ratio analysis, The Dupont Analysis and Trend Analysis are three examples of how financial analysts can use numbers to determine strength of performance and return on investment, (Block, 2005).
When corporations are required to report their financials, they report by the Statement of Financial Accounting Standards, (SFAS), (Block, 2005). This standard includes the income statement, the balance sheet and the statement of cash flows.
With an understanding of the basic financial reporting elements and who is affected by finance, it is time to consider how financial information can be used to make decisions. As mentioned above, more detailed financial analysis yields information on performance. Companies may choose to review their operations or supply chain management if they feel that improving them will reduce costs and increase profitability. Financial information may help steer a company to make decisions about what products or services they want to continue offering, or what services they may want to add.
There are also ethical decisions that must be considered. Take the example of Martha Stewart, who was imprisoned for using insider information to prevent large losses on stock she owned. Financial information may be reported incorrectly or falsified as in the case of Enron and WorldCom. The Sarbanes-Oxley act was created to help remove the threat of individuals with power from covering up financial information to make personal gains.
To conclude, it is important to consider all the key people involved when making financial decisions or reviewing financial performance. There are three essential documents used in financial reporting: the income sheet, the balance sheet and the statement of cash flow, which are all part of the Statement of Financial Accounting Standards. More detailed analysis can be performed using formulas like the Dupont Analysis. Finally, many important decisions are made based on financial data. It is important to ensure ethical handling of potentially damaging information, whether it is helpful or harmful to any party.
Block, Stanley B. Hirt, Geoffrey A. (2005). Foundations of Financial Management, 11e. Chs.
1,2,3. Retrieved on April 1, 2007 from University of Phoenix openResource materials.