Financial reporting and analysis is one of the bedrocks of modern business. While you may already know that financial reporting is important (at least because it’s legally required in most countries), you may not know much beyond that. So, we designed this blog post to answer the following questions:
- What is financial reporting?
- Do all companies do it the same way?
- Why is financial reporting important?
- What are some use cases when it comes to making business decisions?
If you find the business of doing business interesting, or if you just want to upgrade your knowledge on financial analysis and reporting, you’ve found the perfect blog post.
What Is Financial Reporting?
Financial reporting is essentially a way of following standard practices to give the world an accurate depiction of a company’s finances, including their:
All of these financial KPIs are important, because they show the “health” of a company – at least when it comes to money. Financial reports don’t show you much about a company’s culture or management.
We’ll get into the use cases of financial analysis and reporting later on in this article, but for now, it’s enough to know that these “financial health reports” are crucial for anyone who wants to make informed decisions about a business. Such as investing in said business, extending credit or seeing if it has good cashflow in the near term future, and so on. Financial reporting and analysis is also legally required for tax purposes.
As Boundless states, “Financial reporting is used by owners, managers, employees, investors, institutions, government, and others to make important decisions about a business.”
3 Common Financial Report Examples
1) Income Statement
This report tells you how much money a company made (or lost) in a given time period (usually a fiscal year). It does so through showing you revenues earned and expenses paid, with the ultimate goal of showing a company’s profit numbers.
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2) Balance sheet
This gives a snapshot of your assets and liabilities (aka debts) at a given moment in time. It’s definitely possible to be in trouble with your profitability and cashflow situations while having a healthy balance sheet – (especially if you have a lot of money tied up in physical inventory).
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3) Cash Flow Statement
This report shows how much money went into and out of your business in a period of time. The cash flow statement is crucial for things like making sure you have enough money to make payroll.
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Different Ways of Financial Reporting and Analysis
“In a perfect world, investors, board members, and executives would have full confidence in companies’ financial statements…. Unfortunately, that’s not what happens in the real world, for several reasons.”- Where Financial Reporting Still Falls Short, The Harvard Business Review
We won’t get too deep into the “financial reporting rabbit hole” right now, but we can say with certainty that there are many pitfalls associated with financial reporting. Some of them are technical pitfalls, while others are ethical (Enron, anyone?). Right now, it’s enough to understand that there are two main ways that financial reports are standardized:
- The GAAP (Generally Accepted Accounting Principles). This is the system used by the United States, and pretty much nobody else (just like the Imperial measurement system!)
- The IFRS (International Financial Reporting Standards). This system is used by more than 110 countries around the world, including Canada, Australia, India, and China (although China and India have “customized” the IFRS in their own ways).
These differences have real-world consequences. As the HBR article states:
“Take the British confectionary company Cadbury. Just before it was acquired by the U.S. firm Kraft, in 2009, it reported IFRS-based profits of $690 million. Under GAAP those profits totaled only $594 million — almost 14% lower. Similarly, Cadbury’s GAAP -based return on equity was 9% — a full five percentage points lower than it was under IFRS (14%). Such differences are large enough to change an acquisition decision.”
Why Is Financial Reporting Important?
Let’s get down to brass tacks – what’s the point of financial reporting? There are three main reasons:
- It is required by law for tax purposes.
- Financial reporting gives investors, creditors, and other businesses an idea of the financial integrity and creditworthiness of your company.
- It gives you important information you can use to make business decisions – such as whether you should open that new location or not.
Let’s dive into each of these reasons a bit more thoroughly.
This is arguably the most important reason to use financial reports – because you have to! The government uses these reports to make sure that you’re paying your fair share of taxes. Frankly, if financial reports weren’t legally required, most companies would probably use management dashboards instead (at least for internal decision making).
As it is, the government’s requirements for these documents has created an entire industry of auditing firms (like the “Big 4” of KPMG, Ernst & Young, Deloitte, and PWC) that exist to independently review companies financial reports. This auditing process is also a legal requirement.
For other companies, investors, shareholders, etc
If you’re considering investing money in a company, it only makes sense that you’ll want to know how well that company is doing – and according to a standardized litmus test, not measurements that a company made up to make themselves look good.
This is where financial reporting comes into play for investors. This also applies to credit vendors and banks who are considering lending money to a company. In these situations, you want to have an accurate understanding of how likely you are to be paid back – so that you can charge interest accordingly. In this case it’s great to have an investor relations dashboard at hand.
The importance of financial analysis and reporting is also for stakeholders. If you own equity in a firm, or if you are an activist investor who owns a major equity position, you want to have full disclosure of all assets, liabilities, use of cash, revenues, and costs that a company has.You also want to understand if the company is doing something it shouldn’t, (such as in the case of Enron).
Due to a series of laws known as Sarbanes-Oxley, there is more standardization/legal cooperation within the world of financial reporting. These laws are designed to prevent another situation like Enron from happening.
For internal decision-making
As we said earlier, financial reports are frankly not the best tools for making internal business decisions. However, they can serve as the “bedrock” for other reports (such as management reports) that CAN and SHOULD be used to make decisions.
As such, it’s crucial that financial reports are as accurate as possible, because otherwise any management reports (and ensuing decisions) based off them will be based on a shaky foundation. This is where companies can run into trouble using legacy methods of doing financial reports (such as using one massive spreadsheet that multiple users have access to) and where they could see benefits from using financial dashboards instead.
These dashboards can provide at a glance information on the financial health of your company, for both yourself and others. Remember: the government (and outside investors) don’t care WHY your financial reports are inaccurate. They’ll just penalize you for being wrong.
Use-Cases For Financial Reporting
Up until this point, we’ve been pretty general, looking at things from the big picture point of view. Now let’s get a little more tangible and down to earth with some valuable questions that financial reports (and the reports based off them) can help you answer.
Is purchasing this stock a good idea?
If you’re really doing your due diligence on a company that you’re considering investing in as an individual or on behalf of your company, financial reports can give you some (relatively) “hard” data you can use to make your decision.
This is also one way you can gain insight into if a company is potentially under or over priced in the stock market.
Are we profitable? Will we be in the future?
Without financial analysis and reporting, it’s difficult to tell how much money your company is making after paying all of your expenses and payroll. Since one of the main reasons a company exists is to make profits for itself and/or its shareholders, this is pretty crucial information.
How much cash “runway” do we currently possess?
If you’ve ever been a part the management team of a startup, you might have some idea of how stressful it can be to not know if you’re going to be able to “make payroll” or not in the coming months.
Cash is oxygen to a business, where financial reporting and analysis can help you see how many months’ payroll your business can give out while remaining financially solvent, (assuming that revenue numbers stay the same).
This is a good “worst case scenario” exercise to do regularly – and it’s even more sturdy if you assume that your revenues will fall over the next few months compared to your best guess projections.
Do we have capital to invest in new lines of business?
Some companies, like Apple, like to sit on massive amounts of cash. Their strategy is to have this money built up so that they can remain financially solvent even if some pretty catastrophic things happen to the economy.
However, other companies like to invest their money if they can do so while remaining financially healthy. For example, computer chipset manufacturers like Intel upgrade their factories and equipment on a regular basis.
These upgrades are extremely expensive, and while they are a good long-term decision, the company in question must make sure they have the short term cashflow to support these kinds of moves.
Like it or not, financial reporting will be around as long as businesses are making and spending money, for the simple reason that governments will always collect taxes from businesses. As they say, taxes are one of the few certainties in life. While you may not be able to choose if you prepare financial reports or not, you can at least choose how you present them. And with financial dashboards, you can see your company’s financial integrity at a moment’s notice.
To onboard your business on the reporting plane, you can start a free trial and benefit from all the advantages datapine’s solution provides you with!