Every quarter, publicly traded companies release their financial statements to the public. These reports are heavily scrutinized by analysts and investors who use these documents as a yardstick for the company’s current performance.
Financial statements are a snapshot of a company’s current financial situation. For instance, investors may analyze a company’s balance sheet to determine how much leverage (or debt) the business is utilizing. Analysts may comb through the income statement to compare last quarter’s revenue to the same quarter the previous year.
While many companies (both public and private) use financial statements to give insight to potential investors, good financial reporting can deliver much more to management. It provides hard data that leadership can use to make better decisions, and it can also save time and costs that can result from tax preparation and compliance issues.
What Are Financial Statements?
It can be overwhelming to sift through all the information that massive corporations like Microsoft or Apple generate on a quarterly basis. But most of the relevant data can be gathered from three reports: the balance sheet, the income statement, and the cash flow statement.
The balance sheet is an overview of the company’s assets, liabilities, and equity. A company’s assets should always equal its liabilities plus its equity, and thus balance out.
Assets can be cash, property, or inventory, but they can also include intangible assets like patents and trademarks. Liabilities can include loans and mortgages and any outstanding accounts payable. Shareholder’s equity measures how much money would be returned to shareholders if the company liquidated assets and paid off all of its liabilities.
The main goal of an income statement is to track movements in revenue and expenses, which gives managers insight into their company's profitability. Revenue is made from the sale of a company’s products or services but it also includes investments, interest, rent, and royalties.
Expenses are the costs of doing business, which can include Research and Development costs or the expense of making a product. It can also include wages, utility bills, depreciation, and commissions. Net income (or net loss) is calculated by subtracting total expenses from total revenue.
Cash flow statement
The Cash Flow Statement shows how a company makes cash and how well-positioned it is to pay its debt. Cash can be generated (or lost) from the operations of the business, but it can also come from investing in assets like property or equipment. Financing activities like stock issuance can also generate cash.
Why Is Financial Reporting Important?
Financial statements on their own provide a wealth of insight into a company’s operations. Aside from simple reporting of revenue or liabilities, most financial reports also provide comparisons of the company’s current performance to past performance (i.e. comparing this quarter’s net income to the net loss in the same quarter of last year).
Looking at year-over-year changes as a percentage can give greater insight into the company’s trajectory. For example, if operating expenses increase 25% year-over-year, investors may worry about a company’s ability to sustain its business model over time.
Many companies issue a Management Discussion and Analysis (MD&A) report, which is an explanation of their financial statements. It might provide reasons why sales are up this quarter, or give guidance on where the company expects to be next year.
What Metrics Are Found In Financial Reports?
Analysts use several financial ratios to help them identify patterns and trends in financial statements.
The Debt to Equity (D/E) Ratio is a way to determine how much debt a company owes. It’s calculated by dividing total liabilities by total shareholder’s equity, and investors look for a value under 2.
Return on Equity (ROE) is a measure of a company's profitability. Net income is divided by total shareholders equity, and the higher the percentage, the more profitable a business is to its shareholders.
The Quick Ratio, or Acid Test Ratio, measures a company's liquidity. Inventory is subtracted from current assets and that figure is divided by current liabilities. A quick ratio under 1 could indicate that a company doesn’t have enough liquidity to pay its short-term obligations.
Finally, an Asset Turnover Ratio can tell you how effectively a company is using its assets to generate sales. This ratio is calculated by dividing net sales by total assets.
How Can Financial Statements Aid In Decision Making?
Financial statements are a benchmark for comparing a company’s current performance to past performance, and as a way to compare a business to its industry. If your sales increased 5% year-over-year, that might look fine on its own. But when all of your competitors have realized 25% increases over the same time frame, there might be cause for concern.
These documents give company leadership an accurate look at the financial status of their business, and management can use that knowledge to make better decisions. That could be as simple as looking for ways to reduce debt if your D/E ratio is too high. Or it could be looking for ways to cut a recurring expense that's impacting your bottom line.
Can A Professional Improve My Financial Reporting?
Financial statements are a very important tool, but they have limitations. If analysts could predict a company’s future from financial statements alone, they would be quite rich. Still, a financial professional who understands your industry can give you actionable data after reviewing your financial reports.
If your company has outgrown your current accounting software or if you’re using a traditional ERP that can’t support you anymore, contact us to learn more about how Multiview Financial Software’s cutting-edge ERP can optimize your financial operations.