Financial reporting and analysis are essential skills for anyone who wants to understand the financial performance and health of a business. Whether you are an investor, a manager, an accountant, or a student, you need to know how to read, interpret, and use financial statements to make informed decisions.
But what are financial statements? How are they prepared? What do they tell us about a business? And how can we analyze them to gain insights and identify opportunities?
In this blog post, we will answer these questions and more. We will cover the following topics:
- What is financial reporting and analysis?
- Why is financial reporting and analysis important?
- How to write financial statements for a business
- How to analyze financial statements using ratios and other techniques
- How to improve and maintain financial reporting and analysis quality
By the end of this post, you will have a solid foundation of financial reporting and analysis, and you will be able to apply your knowledge to real-world scenarios.
What is financial reporting and analysis?
Financial reporting and analysis is the process of collecting, organizing, presenting, and interpreting financial data for a business. The main purpose of financial reporting and analysis is to provide useful information to internal and external stakeholders, such as managers, investors, creditors, regulators, and the public.
The most common form of financial reporting and analysis is the preparation and presentation of financial statements. Financial statements are formal records that summarize the financial activities and position of a business for a specific period of time, usually a year, a quarter, or a month.
There are four main types of financial statements:
- Income statement: Also known as the profit and loss statement, the income statement shows the revenues, expenses, and profits or losses of a business for a given period. It measures the profitability and performance of a business.
- Balance sheet: Also known as the statement of financial position, the balance sheet shows the assets, liabilities, and equity of a business at a specific point in time. It measures the financial position and solvency of a business.
- Cash flow statement: Also known as the statement of cash flows, the cash flow statement shows the inflows and outflows of cash from operating, investing, and financing activities of a business for a given period. It measures the liquidity and cash generation of a business.
- Statement of changes in equity: Also known as the statement of retained earnings, the statement of changes in equity shows the changes in the equity of a business for a given period. It shows how the profits or losses, dividends, and other transactions affect the owners’ stake in the business.
Financial reporting and analysis also involve the use of various tools and techniques to interpret and evaluate financial statements. These include:
- Ratio analysis: Ratio analysis is the calculation and comparison of financial ratios, which are numerical values derived from financial statements. Ratios can be used to measure and compare various aspects of a business, such as profitability, efficiency, liquidity, solvency, and growth.
- Trend analysis: Trend analysis is the examination of the changes in the financial statements over time. Trend analysis can be used to identify patterns, trends, and anomalies in the financial performance and position of a business.
- Common size analysis: Common size analysis is the expression of the financial statements in percentages, rather than absolute numbers. Common size analysis can be used to compare the financial statements of different businesses, regardless of their size, or to compare the financial statements of the same business over time, regardless of inflation or currency fluctuations.
- Benchmarking: Benchmarking is the comparison of the financial statements of a business with those of its competitors, industry averages, or best practices. Benchmarking can be used to evaluate the strengths and weaknesses of a business and to identify areas for improvement or opportunities for growth.
Why is financial reporting and analysis important?
Financial reporting and analysis is important for several reasons. Some of the main benefits of financial reporting and analysis are:
- Compliance: Financial reporting and analysis helps a business to comply with the legal and regulatory requirements of its jurisdiction. For example, public companies are required to prepare and publish their financial statements according to the accounting standards and rules of their country, and to submit them to the relevant authorities, such as the Securities and Exchange Commission (SEC) in the US, or the Financial Conduct Authority (FCA) in the UK. Failure to comply with these requirements can result in penalties, fines, or legal actions.
- Transparency: Financial reporting and analysis helps a business to communicate its financial information to its stakeholders clearly and consistently. This enhances the transparency and accountability of a business and builds trust and confidence among its stakeholders. For example, investors can use the financial statements to assess the performance and prospects of a business and to make informed decisions about investing in or divesting from it. Similarly, creditors can use the financial statements to evaluate the creditworthiness and risk of a business and to decide whether to lend to or borrow from it.
- Decision making: Financial reporting and analysis help a business to make better decisions for its future. By analyzing the financial statements, a business can identify its strengths and weaknesses, opportunities and threats, and goals and strategies. For example, managers can use the financial statements to plan and budget for the next period, allocate resources and control costs, monitor and evaluate the results, and to take corrective actions if needed. Likewise, employees can use the financial statements to understand the financial situation and direction of the business and to align their actions and expectations with it.
How to write financial statements for a business
Writing financial statements for a business is not a simple task. It requires a good understanding of the accounting principles and standards, the business operations and transactions, and the financial reporting and analysis objectives and users.
The process of writing financial statements for a business can be summarized in the following steps:
- Identify the accounting framework: The first step is to identify the accounting framework that the business follows or needs to follow. The accounting framework is the set of rules and guidelines that govern how financial statements are prepared and presented. There are different accounting frameworks in different countries and regions, such as the Generally Accepted Accounting Principles (GAAP) in the US, the International Financial Reporting Standards (IFRS) in the EU, and the Accounting Standards for Private Enterprises (ASPE) in Canada. The choice of the accounting framework depends on factors such as the legal and regulatory requirements, the nature and size of the business, and the preferences and expectations of the stakeholders.
- Collect and record the financial data: The next step is to collect and record the financial data of the business for the period that the financial statements cover. The financial data includes the revenues, expenses, assets, liabilities, equity, and cash flows of the business, as well as any other relevant information, such as accounting policies, estimates, and judgments. The financial data is recorded in the accounting system, which can be manual or computerized, using the double-entry bookkeeping method. The double-entry bookkeeping method ensures that every transaction affects two accounts, one as a debit and one as a credit and that the total debits equal the total credits at all times.
- Prepare the trial balance: The third step is to prepare the trial balance, which is a list of all the accounts and their balances at the end of the period. The trial balance is used to check the accuracy and completeness of the accounting records and to identify and correct any errors or discrepancies. The trial balance should have two columns, one for the debits and one for the credits, and the sum of each column should be equal. If the trial balance does not balance, it means that there is an error in the accounting records, and it needs to be located and fixed before proceeding to the next step.
- Adjust the entries: The fourth step is to adjust the entries, which are the journal entries that are made at the end of the period to update the accounts and reflect the true financial position and performance of the business. There are four types of adjusting entries: accruals, deferrals, estimates, and reclassifications. Accruals are the entries that record the revenues and expenses that have occurred but have not been recorded yet. Deferrals are the entries that record the revenues and expenses that have been recorded but have not occurred yet. Estimates are the entries that record the revenues and expenses that are based on assumptions or calculations, such as depreciation, bad debts, or taxes. Reclassifications are the entries that record the changes in the classification or presentation of the accounts, such as the separation of current and non-current assets and liabilities, or the elimination of intercompany transactions.
- Prepare the adjusted trial balance: The fifth step is to prepare the adjusted trial balance, which is a list of all the accounts and their balances after the adjusting entries have been made. The adjusted trial balance is used to verify that the accounts are still in balance and to prepare the financial statements. The adjusted trial balance should have the same format and structure as the trial balance, with two columns for the debits and credits, and the sum of each column should be equal.
- Prepare the financial statements: The final step is to prepare the financial statements, which are the documents that summarize and communicate the financial information of the business to the stakeholders. The financial statements are prepared using the data from the adjusted trial balance, and following the accounting framework and the financial reporting and analysis objectives and users. The financial statements usually include the income statement, the balance sheet, the cash flow statement, and the statement of changes in equity, as well as the notes and disclosures that explain and supplement the financial statements.
How to analyze financial statements using ratios and other techniques
Analyzing financial statements using ratios and other techniques is the process of evaluating and interpreting the financial information of a business to gain insights and identify opportunities. The main purpose of analyzing financial statements is to assess the past, present, and future performance and position of a business, and to compare it with its peers, competitors, industry, or benchmarks.
Many ratios and techniques can be used to analyze financial statements, depending on the objectives and users of the analysis. Some of the most common and useful ones are:
- Profitability ratios: Profitability ratios measure the ability of a business to generate profits from its revenues, assets, and equity. Some examples of profitability ratios are gross profit margin, operating profit margin, net profit margin, return on assets, return on equity, and return on invested capital.
- Efficiency ratios: Efficiency ratios measure the ability of a business to use its resources effectively and productively. Some examples of efficiency ratios are asset turnover, inventory turnover, receivables turnover, payables turnover, and working capital turnover.
- Liquidity ratios: Liquidity ratios measure the ability of a business to meet its short-term obligations and cash needs. Some examples of liquidity ratios are the current ratio, quick ratio, cash ratio, and cash conversion cycle.
- Solvency ratios: Solvency ratios measure the ability of a business to meet its long-term obligations and debt payments. Some examples of solvency ratios are debt-to-equity ratio, debt-to-assets ratio, interest coverage ratio, and times interest earned ratio.
- Growth ratios: Growth ratios measure the rate of change in the revenues, profits, assets, and equity of a business over time. Some examples of growth ratios are revenue growth rate, earnings growth rate, asset growth rate, and equity growth rate.
To calculate and interpret these ratios, we need to follow these steps:
- Select the relevant ratios: The first step is to select the relevant ratios that suit the objectives and users of the analysis. For example, if we want to analyze the profitability of a business, we would choose the profitability ratios. If we want to analyze the liquidity of a business, we would choose the liquidity ratios. And so on.
- Gather the data: The next step is to gather the data that is needed to calculate the ratios. The data is usually obtained from the financial statements of the business, or other sources, such as market data, industry reports, or historical data.
- Calculate the ratios: The third step is to calculate the ratios using the data and the formulas. The formulas for the ratios vary depending on the accounting framework and the definitions used by the business. For example, the formula for the gross profit margin can be gross profit/revenue, or gross profit/cost of goods sold, depending on how the business defines its gross profit and revenue. Therefore, it is important to be consistent and clear when calculating the ratios and to use the same formulas and data for comparison purposes.
- Interpret the ratios: The final step is to interpret the ratios and draw conclusions from them. The interpretation of the ratios depends on the context and the purpose of the analysis. For example, a high gross profit margin can indicate that the business has a strong competitive advantage, that it has a high pricing power, that it has a low-cost structure, or a combination of these factors. However, a high gross profit margin can also indicate that the business is facing a low demand, or that it has a low-quality product, or that it has a high risk of obsolescence, or a combination of these factors. Therefore, it is important to consider the qualitative and quantitative factors that affect the ratios, and to compare them with the industry averages, the competitors, the benchmarks, and the historical trends, to get a complete and accurate picture of the business.
How to improve and maintain financial reporting and analysis quality
Improving and maintaining financial reporting and analysis quality is crucial for the success and sustainability of a business. Financial reporting and analysis quality refers to the reliability, relevance, comparability, and timeliness of the financial information that is provided and used by the stakeholders.
There are many ways to improve and maintain financial reporting and analysis quality, such as:
- Adopting and following the accounting standards and principles: Adopting and following the accounting standards and principles that are applicable and appropriate for the business is the foundation of financial reporting and analysis quality.
The accounting standards and principles provide the rules and guidelines for preparing and presenting the financial statements, and ensure that the financial information is consistent, comparable, and transparent. For example, the GAAP, the IFRS, or the ASPE are some of the accounting standards and principles that are widely used and recognized by the stakeholders. - Implementing and monitoring the internal controls and procedures: Implementing and monitoring the internal controls and procedures that are designed to prevent, detect, and correct any errors, frauds, or irregularities in the financial reporting and analysis process is another way to improve and maintain financial reporting and analysis quality. The internal controls and procedures include the policies, systems, methods, and activities that are used to safeguard the assets, ensure the accuracy and completeness of the records, and comply with the laws and regulations.
For example, the segregation of duties, the authorization and approval, the reconciliation and verification, and the documentation and review are some of the internal controls and procedures that are commonly used and implemented by businesses. - Hiring and training the qualified and competent staff: Hiring and training the qualified and competent staff who are responsible for the financial reporting and analysis process is also a way to improve and maintain financial reporting and analysis quality. The staff should have the knowledge, skills, and experience that are relevant and necessary for the financial reporting and analysis tasks, and they should be updated and educated on the accounting standards and principles, the internal controls and procedures, and the best practices and trends.
For example, the accountants, the auditors, the analysts, and the managers are some of the staff who are involved in the financial reporting and analysis process, and they should be hired and trained accordingly. - Using and applying the tools and techniques: Using and applying the tools and techniques that are available and suitable for the financial reporting and analysis process is another way to improve and maintain financial reporting and analysis quality.
The tools and techniques include the software, the models, the methods, and the frameworks that are used to collect, organize, present, and interpret the financial data, and to provide useful and meaningful information to the stakeholders. For example, the accounting software, the spreadsheet software, the ratio analysis, the trend analysis, the common size analysis, and the benchmarking are some of the tools and techniques that are widely used and applied by businesses.
By improving and maintaining financial reporting and analysis quality, a business can enhance its credibility, reputation, and value, and achieve its goals and objectives.
