Financial Reporting Basics: 4 Key Financial Reports Explained

The real story of a business’s triumphs and struggles is reflected in its financial reporting. Your company’s financial reports are the ultimate business X-ray, exposing the vital signs of profitability, stability, and cash flow. These documents provide the framework for making informed decisions. Accurate financial reporting empowers everyone from the business owner to the curious investor to the sharp-eyed regulator. It is also the key to truly understanding what makes a business tick.

In this article, learn about the most common types of financial reports, who regularly uses financial reporting, and what makes financial reporting important.

What are financial reports?

Financial reports, also known as financial statements, are formal records that summarize a company’s financial activities and position over a specific period, like a month or a year. The financial reporting process provides a structured way to present relevant financial information to a wide range of users. The main types of financial statements include the balance sheet, income statement, statement of cash flows, and statement of shareholder equity. 

Types of financial reports

• Income statement
• Balance sheet
• Cash flow statement
• Statement of shareholder equity

These common financial statements provide a comprehensive view of a company’s finances:

Income statement

The income statement, also known as the profit and loss (P&L) statement, details a company’s revenues, expenses, and ultimately, the company’s net income or net loss over a period of time. The income statement reveals how profitable a business has been and helps assess its operational efficiency and earnings trends.

The P&L statement typically starts with revenue and subtracts the cost of goods sold to arrive at gross profit. Then it deducts operating expenses (like salaries, rent, and utilities) to determine operating income. Non-operating items like interest income or expenses, and gains and losses are then considered, leading to income before taxes, and finally, net income after taxes. This determines a company’s net worth.

Balance sheet

The balance sheet provides an overall view of a company’s assets, current liabilities, and equity at a specific point in time. It adheres to the fundamental accounting equation: Assets = Liabilities + Equity.

It indicates a company’s financial position, its ability to meet short-term and long-term obligations (liquidity and solvency), and the proportion of financing from debt versus equity.

The key components of the balance sheet are assets, liabilities, and equity. Here are a few examples of each:

• Assets. Cash, accounts receivable, inventory, property, and equipment.

• Liabilities. Accounts payable, salaries payable, loans, and bonds payable.

• Equity. Common stocks and retained earnings.

Cash flow statement

The cash flow statement tracks the movement of a company’s cash over a specific period using information compiled in the income statement and balance sheet. Whereas the income statement includes accruals (money earned but not yet received), the cash flow statement purely reflects cash that has changed hands. An important element of financial reporting, it provides insights into a company’s ability to generate cash, meet its short-term obligations, fund its future growth, and distribute dividend payments.

Cash flows are categorized into three main activities:

• Operating activities. This includes cash generated from the normal day-to-day running of the business (e.g., cash from sales, cash paid to suppliers and employees).

• Investing activities. Cash flow related to the purchase and sale of long-term assets (e.g., buying or selling property, plant and equipment, investments in other companies) makes up investing activities.

• Financing activities. Cash flow related to how the company is funded (e.g., issuing or repaying debt, issuing or repurchasing stock, dividend payments) constitutes financing activities.

Statement of shareholder equity

For public companies, the statement of shareholder equity details the changes in the owner’s equity (or shareholders’ equity for corporations) over a specific period. It reconciles the beginning and ending balances of equity accounts. This report explains how the owner’s stake in the company has changed over time due to factors like profitability, distributions to owners, and capital transactions.

It typically starts with the beginning balance of each equity component, like common stock or retained earnings, and then shows additions like net income and stock issuances. Deductions such as net losses, dividend payments, and stock repurchases are also factored in to arrive at the ending balance of shareholders’ equity.

Who uses financial reports?

• Investors
• Lenders and creditors
• Business owners
• Regulatory institutions
• Unions

A wide range of stakeholders rely on financial reporting to make informed decisions. Investors and creditors assess a company’s financial health and potential returns. Business owners review financial reports for internal operations and strategic planning. Regulators use them to monitor compliance, and unions use them to evaluate a company’s financial status for negotiations.

Here’s a more detailed breakdown:

Investors

Whether it’s an individual investor, an institutional investor (like a mutual fund or pension fund), or a venture capitalist, all investors rely on the income statement to determine the company’s ability to generate profits over time. Investors analyze metrics like net income, gross profit margin, and operating margin to understand the efficiency and profitability of the business. Comparing income statements across different periods helps identify business growth or decline.

Investors look at the balance sheet to determine the company’s debt-to-equity ratio and asset structure. They also analyze investing and financing activities to understand capital expenditures and funding strategies. Investors calculate key return metrics like return on equity (ROE) and return on assets (ROA) to evaluate how effectively the company is using invested capital to generate profits. This historical financial data is also useful for building financial models to estimate the company’s future profitability and cash flow.

Lenders and creditors

Creditors primarily focus on the company’s ability to repay its debt obligations (principal and interest). They scrutinize the balance sheet to assess the company’s debt levels and its assets that could serve as collateral. Liquidity ratios like the current ratio and quick ratio (which are calculated based on information in the balance sheet) are indicators of the company’s short-term ability to meet its obligations.

The cash flow statement is especially important for creditors. They use financial analysis of the cash flow to determine if the company generates enough cash to cover debt payments. They also look at free cash flow (cash flow from operations less capital expenditures) as a measure of how much cash is available for debt repayment.

Business owners

Business owners and the teams responsible for operations and strategic decision-making use financial reports to track the company’s performance against budgets, targets, and prior periods. The income statement, in particular, helps monitor the revenue generated, cost control, and overall profitability. By analyzing the income statement and statement of cash flows, management can identify key areas for improvement in efficiency, cost management, and resource allocation.

Regulatory institutions

Regulatory institutions include government agencies and organizations responsible for overseeing and regulating financial markets and institutions. They protect investors, maintain market integrity, and ensure the stability of the financial system. The Securities and Exchange Commission (SEC) is primarily responsible for the oversight of public companies.

Regulators mandate that some companies file periodic financial reports. They use these annual reports to monitor compliance with accounting standards such as generally accepted accounting principles (GAAP) and other regulatory requirements. They also analyze financial statements to identify potential risks and vulnerabilities within individual companies and the broader financial system. They look for red flags, such as high levels of debt, declining profitability, or unusual cash flow patterns, which might indicate financial distress or mismanagement.

Unions

Unions analyze a company’s financial reports, particularly the income statement and balance sheet, to understand its profitability, revenue trends, and overall financial stability. This information is crucial when negotiating wages and benefits. Unions may argue that profitable companies have the capacity to offer better compensation.

If a company claims it can’t afford wage increases or improved benefits due to financial constraints, the union will review its financial reports to verify these claims and assess the business’s financial health. They may request further detailed financial information to determine the legitimacy of the employer’s position.