Investors use financial statements to obtain valuable information used in the valuation and credit analysis of companies. This makes it important to understand how business accounting is done and which principles guide financial statement preparation. Knowledge of accounting helps investors determine an assets' value, understand a company's financing sources, calculate profitability, and estimate risks embedded in a company's balance sheet.
Critically Importantin PerformingInvestment Analysis
Understanding a company's classification of its assets, liabilities, and valuation methods in financial accounting is paramount in investment and credit analysis. For example, according toU.S. Generally Accepted Accounting Principles (GAAP), the asset value is, for the most part, based on historical cost and does not reflect its market value. Therefore, obsolete equipment with positive book value may be worthless if the company attempts to sell it. Also, the value for a certain class of assets is based onmanagement's judgment and may not reflect its true economic value.
For instance, if the value of the company's goodwill is based on unrealistic assumptions, the management may have to take a large earnings charge in the future. Investors who have a strong knowledge of business accounting can be ahead of the curve by identifying such problems early on.
Learning Howa Company Finances TheirOperations
Another question that business accounting helps answer relates to the mix of debt and equity used to finance a company's operations. The ability to identify debt and equity is crucial in determining the company's value since the debt-to-equity ratio is commonly used in measuring a company's idiosyncratic risk. Although most information on debt and equity comes from the balance sheet, certain debt items require further digging and deep knowledge of business accounting.
For example, companies often choose to lease property instead of buying it. Under the U.S. GAAP, operating leases are not required to be included as a liability. However, operating lease payments are akin to debt payments, and investors may wish to treat the present value of operating leases as debt.
Accurately Estimating Profitability and Risks
Profitability is the cornerstone of ratio analysis and investment valuation. Financial analysis is based on the company's future earnings, and most earnings predictions use current profits as a base. Investors with a strong grasp of financial accounting can quickly decipher whether certain line items on the income statement are non-recurring and are not expected to occur in the future.
Estimating uncertaintyor riskof assets is one of the most important steps in investment valuation. Although financial statements do not estimate risk directly, they provide many useful disclosures in the notes, which help identify risk. Investors with strong accounting backgrounds use a company's financial reports to identify key risk areas that can point to potential losses in asset values. Also, investors use financial statements to calculate financial ratios that assist in estimating a company's liquidity and default risks.
Finally, investors may need to possess extensive knowledge of different accounting standards to compare companies from different countries. Although accounting principles gradually converge across the globe, differences still persist and complicate the comparability of financial records.
FAQs
Knowledge of accounting helps investors determine an assets' value, understand a company's financing sources, calculate profitability, and estimate risks embedded in a company's balance sheet.
Why is it important to understand accounting? ›
Accounting allows you to develop skills such as leadership and strategic-thinking, valuable skills when it comes to working in the world of business and finance. They allow you to guide organisations with their financial decision-making and can also influence business growth.
Why is financial information important to investors? ›
Financial statements provide a snapshot of a corporation's financial health, giving insight into its performance, operations, and cash flow. Financial statements are essential since they provide information about a company's revenue, expenses, profitability, and debt.
Why do shareholders need accounting information? ›
Owners use the financial information to assess the financial performance of the business and make decisions such as whether or not to purchase additional stock, sell existing stock, or maintain the current level of stock ownership. Other decisions stockholders make may be influenced by the type of company.
How do you think accounting standards help investors? ›
Accounting standards ensure the financial statements from multiple companies are comparable. Because all entities follow the same rules, accounting standards make the financial statements credible and allow for more economic decisions based on accurate and consistent information.
What are the 3 benefits from understanding accounting? ›
No matter your current role, learning about financial accounting can be highly beneficial. You'll be able to understand your personal and organizational finances, make more data-driven decisions, and advance your career.
What are the 5 main reasons why accounting is important? ›
The importance of accounting
- Tracking income and expenditure.
- Ensuring statutory compliance.
- Provide quantitative financial information.
- Assess the performance of a business or organisation.
- Provide data to support decision making.
Balance sheets are useful to investors because they show how much a company is actually worth. Some of the information on a balance sheet is useful simply in and of itself. For example, you can check things like the value of the company's assets and how much debt a company has.
Which financial statement is most important to investors? ›
Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.
Why is non financial information important to investors? ›
As this cannot be judged by financial and accounting information alone, non-financial information is also used to determine the company's ability to create value over the medium to long term.
Investment accounting is a specialized form of accounting that focuses on tracking and monitoring investment activity. Investment accountants typically work for financial institutions such as banks or credit unions, but may also work as freelancers or as part of an advisory firm.
Why is accounting information important to management investors and bankers? ›
Accounting helps to communicate company results to various users. Investors, lenders, and other creditors are the primary external users of accounting information. Investors may be deciding to buy shares in the company, while lenders need to analyze their risk in deciding to lend.
What do investors and creditors want to know that accounting can answer? ›
there are three main areas where financial accounting helps with decision-making: It provides investors with a baseline of analysis for—and comparison between—the financial health of securities-issuing corporations. It helps creditors assess the solvency, liquidity, and creditworthiness of businesses.
