Let’s take a closer look at the importance of financial reporting, including key types of financial reports, why financial reporting is important to you and your business, and real-world examples of how you can leverage financial reporting. After all, when it comes to making financial decisions, hard data can help you remain objective.
What is financial reporting?
Financial reporting is an objective way to assess a company’s financial health and company financials. In general, financial reporting provides information about your business’s revenue, expenses, profits, cash flow, and profitability.
This type of reporting uses financial statements to disclose financial information to internal and external stakeholders. Business owners may decide to generate financial reports quarterly or annually.
Businesses that operate outside the U.S. produce reports that comply with international accounting standards. These rules are referred to as the International Financial Reporting Standards (IFRS).
4 types of financial reports
Four common financial reports follow standard accounting practices to give you and your stakeholders an accurate picture of your company’s finances. Understanding financial statements is the framework for understanding your company’s financial health.
1. Balance sheet
Assets – liabilities = equity
Assets are resources your company uses to generate revenue and profits. Liabilities are the amounts your company owes to other parties. Equity—also known as owner’s equity, shareholder equity, or stockholder’s equity—is the difference between the assets and liabilities.
2. Income statement
An income statement, also known as a profit and loss statement, shows your company’s revenues and expenses for an accounting period. The income statement formula subtracts expenses from revenue to determine net income.
Revenue – expenses = net income
Income statements can be tracked quarterly or annually. Included in the income statement are:
- Primary expenses, including cost of goods sold and general administrative costs
- Secondary expenses such as debt interest and capital loss
- Operating revenue
- Net and gross revenue
- Nonoperating revenue from accrued interest and royalty payments
3. Cash flow statement
The cash flow statement, or statement of cash flows, shows the company’s cash inflows and outflows for a period of time. Cash flows are separated into operating, investing, and financing activities. The cash flow statement formula adds the beginning cash balance with net changes in each activity to determine the ending cash balance.
Beginning balance in cash + net changes in operating, investing, and financing activities = ending cash balance
Cash flow statements typically contain the following information:
- Operational activities: Accounts receivable and payable, wages, and income tax
- Primary investments: Use of investment earnings, issued loans, and asset sales
- Secondary investments: Office space, fixed-asset purchases, property
- Financing activities: Debt repayments, stock repurchases, and payable dividends
4. Statement of retained earnings
The statement of retained earnings outlines the changes in retained earnings for a company over a specified period. It can also be known as a statement of owner’s equity, a statement of shareholders’ equity, or an equity statement.
This statement is used by analysts to determine how a business’s profits are utilized. The formula for a statement of retained earnings is as follows:
Retained earnings beginning period balance + current period net profit (– current period net loss) – cash dividends – stock dividends = retained earnings
Why is financial reporting important?
Financial reporting makes it easy to understand how your company is performing financially. CFOs can use this information to calculate the breakeven point, cash collections, and even debt financing. Financial reports are also required for taxes and accounting purposes.
Financial reports provide you with the critical information you need to track KPIs. The more often you generate and review your financial reports, the more accurate your KPIs will be. Below are the common reasons why financial reporting is important for your small business.
The IRS uses various financial reports to ensure you’re paying the right amount in taxes. Accurate financial reporting can help decrease your tax burden by making sure you’re not overpaying and can mitigate the risk of error.
Investors will want to see your financial reports to better understand your company’s financial condition before they decide to invest. Investors prefer companies that can generate higher profits and cash inflows each year.
Financial reports can help you make tough business decisions. With accessible financial data, you can make those decisions based on hard numbers rather than gut feelings or guesswork. This allows you to identify things like trends and roadblocks in real time, giving you the opportunity to either continue in a positive direction or to make changes as needed.
Keeping accurate financial reports ensures that your small business is compliant with mandatory accounting regulations. Each financial reporting document you use is reviewed by multiple regulatory institutions, such as the IRS and the U.S. Securities and Exchange Commission (SEC), so it’s imperative that you keep accurate records to avoid penalties and further auditing.
Evaluating company health
Financial reports allow you to make business decisions using real financial data. This allows you to be completely objective when assessing the financial health of your company, but you can’t get the full picture without tracking that data against KPIs. KPIs allow you to keep tabs on your business’s financial performance. Here are three actionable KPIs you can use to measure your financial health:
Gross profit margin
Your gross profit margin shows you how much of your revenue is profit after you factor in expenses like the cost of production. The gross profit margin formula first subtracts cost of goods sold from revenue, then divides that number by revenue. The gross profit margin formula follows:
(Revenue – costs of goods sold) ÷ revenue = gross profit margin
Keep an eye on your gross profit margin. If your gross profit margin percentage begins to dip, you need to look for ways to lower your expenses.
Your net profit is the amount of money you have after you’ve paid all your bills and expenses. Net profit is your bottom line. The net profit formula subtracts total expenses from total revenue. The net profit formula follows:
Total revenue – total expenses = net profit
In general, you’ll want to have net profit rather than net loss. Net profit means your business is making money. If your net profit begins to drop, you’ll want to investigate where your company is losing money, rather than making it.
Use the current ratio KPI to determine if you have enough money to fund a large purchase, like a new piece of machinery. The current ratio formula divides current assets by current liabilities. The current ratio formula follows:
Current assets ÷ current liabilities = current ratio
A current ratio of less than 100% is cause for concern. It means you may not have enough cash coming in to pay your bills. Tracking this KPI can alert you to incoming cash flow problems.
Financial reporting regulations
Since these financial reports are the very essence of your business’s cash flow, they are subject to regulatory standards. For example, the IRS and other tax agents gather this financial information to monitor your business compliance with tax regulations.
The SEC oversees capital markets and regulates investment activities within the stock markets. Depending on funding and type of business, the SEC requires public companies to disclose financial information on a regular basis for investors to review.
Real-world financial reporting
It can be easy to understand why financial reporting is important in the big-picture sense, but it might be tricky to understand the importance of this topic from the day-to-day lens. Below are some real-world examples of when financial reporting can be helpful to you and your small business.
Financial reports tell you at a glance how much money your business is making after your expenses are paid, or your profitability ratio. This is incredibly important information to know since profitability is what keeps your business thriving.
Although not so obvious, financial reporting can have a major impact on a company’s stock price. Investors tend to look at financial statements when making investment decisions—if this information is better or worse than expected, it could swing the stock price in either direction. Oftentimes, investors use financial ratios based on the financial reports to make assumptions about the financial health of a company.
Whether you have a large financial cushion or have your money spread across several investments, it’s important to know exactly what kind of working capital you have at any particular time. For example, it’s important to know if you have the capital to make necessary upgrades to your equipment when needed.
As a small business owner, an essential part of running a business is to make sure that your employees are paid. After all, no employee wants to work for free, so being able to make payroll on time is an important aspect of running a business smoothly. Financial reporting will help give you an idea of your cash flow to ensure that you won’t be putting yourself or your employees at risk for nonpayment.
Financial reporting: The backbone of your business success
While it may sound daunting, financial reporting is perhaps the most crucial thing a company can do. After all, this gives you the capability to make strategic and forward-thinking decisions for you and your business while maintaining compliance with the government. With proper financial forecasting, you’ll be able to take your business to the next level.