Importance of Financial Statements in Company Valuation (Essay Sample)

IMPORTANCE OF FINANCIAL STATEMENTS IN COMPANY VALUATION
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Importance of Financial Statements in Company Valuation
A company’s financial statements are considered an integral source of information for both internal and external stakeholders. Primarily, the documents detail the historical performance of a company in the market, allowing various parties to establish the firm's position comprehensively. Notably, the release of these documents to the public is compulsory for publicly traded companies. The assertion that financial statements are vital tools in the company's valuation has been disputed under recent events, especially with the emergence of technology firms. Presently, the information contained in financial statements is sparingly considered during company valuation.
Each financial statement contains important financial details applicable to the valuation of an organization. According to ICMAI (2014, p.13), “the most typically used financial statements include the income statement, balance sheet, and cash flow statement.” The income statement provides details concerning revenues, costs, and expenses of a company within a given period (Osadchy et al. 2018). The document can also be referred to as the profit and loss statement and is used to calculate the net income of a company (Köseoğlu & Almeany 2020). In that case, any party interested who wants to determine the amounts of profits made by a company in a particular period would have to review this document. The balance sheet details the financial status of a firm through a listing of its assets, liabilities, and owner's equity during a particular period (Ausloos 2020). Overall, the financial statement offers an insight into the fiscal position of an organization at a certain point in time. A cash flow statement captures information concerning sources and uses of cash and cash equivalents within a certain accounting period (ICMAI 2014). “This document contains the information under three main categories, which include cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities” (Köseoğlu & Almeany 2020, p.13). Each of these segments contains a unique combination of cash inflows and outflows. As demonstrated above, the statements can be used for company valuation.
The utility of details contained in a particular financial statement is determined by the nature of the valuation model to be applied. Several methods can be used to measure the fair value of a business (Shmidlin 2014). First, a company can apply a market capitalization approach, which does not source information from any of the three financial statements. Instead, this method entails multiplying a company’s stock price by the shares issued (Shmidlin 2014). However, a statement of owner's equity can be used to determine the number of common stocks issued by the company. Although less frequently released, the document is considered a financial statement. Second, parties can also use the time revenue method as a valuation model (Köseoğlu & Almeany 2020). The process involves applying a certain multiplier to a stream of revenues generated in a certain period to determine the value of an organization (Frešer, Širec & Tominc 2020). Markedly, the nature of the multiplier utilized is mainly influenced by the industry and the economic environment of the company. Under such circumstances, financial statements, such as cash flow statements and income statements, would be needed to provide the necessary data.
Third, an earnings multiplier model can be employed in the valuation of a company. Unlike in the previous method, in this approach, the multiplier is applied to the profits of a company. This multiplier adjusts the current price/earnings ratio to match the current interest rates (Massari, Gianfrate & Zanetti 2014). The data needed to complete this process is contained in the financial statements of a company. Fourth, discounted cash flow (DCF) model is a popularly used company valuation approach. Notably, this method is similar to earning multiplier since it involves discounting projected future cash flow to determine the present value of a company. The information needed in this process is mainly obtained from the cash flow statement of a firm (Massari, Gianfrate & Zanetti 2014). Fifth, a balance sheet is a vital document when applying a book value method. The model entails subtracting total liabilities from the total assets to measure shareholder's equity (Shmidlin 2014). Sixth, a firm can use the liquidation valuation method, which is the net cash that a business would receive if all its assets were sold and liabilities settled (Shmidlin 2014). Shmidlin (2014) states that these details would require the analysis of the company’s balance sheet. Overall, the utility of the information contained in a financial statement is mainly determined by the valuation model used.
However, contemporary approaches to company valuation have significantly evolved, making financial statements less useful in the process. Modern valuation approaches are mainly concerned about the future transactions of a company, which differs from the historical information contained in financial statements (Frešer, Širec & Tominc 2020). Additionally, most investors deem the methods described above less insightful since they do not comprehensively capture the value of assets such as trademarks, brand names, and management effectiveness (Frešer, Širec & Tominc 2020). A study conducted by Hail (2013) discovered that financial reports, such as balance sheets and income statements have become less relevant in the valuation of a company. The occurrence and constant reoccurrence of accounting scandals and financial crises have resulted in a lack of dependability of the information contained in these documents.
Additionally, Miciuła, Kadłubek and Stępień (2020) maintain that the information contained in a balance sheet does not contain the actual market value since other variables, such as economy of the nation, the suitability of the industry, the firm’s growth approach, human resources, and the method used to deploy the assets, have to be considered. Govindarajan, Rajgopal and Srivastava (2018) comment that, in a digital company, an income statement and a balance sheet are of limited salience. For instance, the latter mainly reports the physical assets owned by a firm within its confines (Govindarajan, Rajgopal & Srivastava 2018). However, digital businesses have numerous intangible assets that are located in different ecosystems. This situation makes the information contained in a balance sheet of a digital company inaccurate in capturing its valuation. In addition, the income statement of a digital company is challenging to analyze since an increase in returns is not always attributed to an expense. Therefore, the two financial statements cannot be used to establish the value of a digital company (Govindarajan, Rajgopal & Srivastava 2018). Despite th