It is important for managers to understand different financial tools because they all provide valuable information about some economic aspect of the organization. One example may be income statement which is also known as profit & loss statement. Income statement tells managers about the profitability of the organization by showing revenue as well as the costs and expenses incurred to generate the revenue. By looking at the income statement, managers may be able to identify the costs that may be spiraling out of control and could take steps to contain them, especially if they have been increasing at a faster pace than the revenue over the long term.
Another important financial statement is balance sheet which tells managers the assets owned by the organization as well as the sources of funds used to acquire those assets such as debt and equity. Balance sheet may also give valuable information about the liquidity position of the organization and may alert to potential problems such as growing financial leverage. It may also offer clues regarding operations such as accounts payable growing at faster-than-average pace which may hint at impending liquidity crisis.
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"Importance of Financial Tools".
Cash flow statement helps the managers assess the liquidity position of the organization by giving them detailed picture of cash inflows and outflows. Cash flow statement is important because the firm needs cash to carry out day-to-day operations.
There are also other financial tools such as ratios that help managers better understand their respective organizations. One of the major benefits of financial ratios is that they provide good picture of any particular aspect of operations, the managers may be trying to understand better. For example, the manager who wants to measure the short-term liquidity status of the organization may refer to short-term liquidity ratios such as current ratio and/or quick ratio. A manager who wants to understand how well the organization is utilizing its assets may refer to asset utilization ratios such as Return-on-Assets (ROA). The manager looking to determine the profitability of the organization may opt for Net Profit Margin and Gross Profit Margin among other ratios.
There are even ratios that help the organization determine the efficiency of its operations, For example, Inventory Turnover Ratio may help the manager understand the performance of organization’s inventory management system. Accounts Receivables Ratio may help manager understand whether the firm’s credit policy to customers is appropriate or needs revision. Similarly, Accounts Payable Ratio may help the manager determine how well it is managing business relationship with suppliers.
One of the most important stakeholders of any organization is shareholders. Ratios like Dividend Yield Ratio help managers evaluate whether shareholders are getting appropriate return on their investment.
Many may assume that the financial tools that depict profitability of the organization such as income statement are the most important but in my opinion, the most important financial tool is cash flow statement. Profitability is important and there is no denying that but liquidity is even more important for the survival of the organization. An organization may be extremely profitable but it can still go out of business if it doesn’t have adequate liquidity. We have seen this numerous times, especially in case of new businesses as well as during economic crisis such as the recent financial crisis. Firms need liquid assets such as cash to manage day-to-day operations. Liquidity is so important that some business partners such as suppliers are even willing to offer trade discounts for immediate payment. Another reason why liquidity indicators such as cash flow statement are important is that profitability indicators are easier to manipulate as compared to liquidity indicators.
