Lita Epstein - Reading Financial Reports For Dummies

Part 1

IN THIS PART …

Explore the types of financial reports and get to know the key financial statements.

Discover business types and their tax rules, including sole proprietorships, partnerships, and limited liability companies.

Differentiate between public and private companies, and understand what it means when a company decides to go public.

Understand accounting basics — enough to understand different kinds of profit, and to distinguish debits from credits.

Chapter 1

IN THIS CHAPTER

Reviewing the importance of financial reports

Exploring the different types of financial reporting

Discovering the key financial statements

F inancial reports give a snapshot of a company's value at the end of a particular period, as well as a view of the company's operations and whether it made a profit. The business world couldn't function without financial reports. Yes, fewer scandals would be exposed because companies wouldn't be tempted to paint false but pretty financial pictures, but you'd still need a way to gauge a firm's financial health.

Currently, nothing's available that can possibly replace financial reports. Nothing can be substituted that'd give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the folks who work for a company wouldn't know how to make it more efficient and profitable because they wouldn't have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures and make plans for future improvements.

This chapter introduces you to the many facets of financial reports and shows you how internal and external players use them to evaluate a company's financial health.

Financial reporting gives readers a summary of what happens in a company based purely on the numbers. The numbers that tell the tale include the following:

Assets: The cash, marketable securities, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business that a company holds

Liabilities: Money a company owes to outsiders, such as loans, bonds, and unpaid bills

Equity: Money invested in the company

Sales: Products or services that customers purchase

Costs and expenses: Money spent to operate a business, such as expenditures for production, compensation for employees, operation of buildings and factories, or supplies to run the offices

Profit or loss: The amount of money a company earns or loses

Cash flow: The amount of money that flows into and out of a business during the time period being reported

Without financial reporting, you'd have no idea where a company stands financially. Sure, you'd know how much money the business has in its bank accounts, but you wouldn't know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much the firm owes, or even how much the firm owns. As an investor, if you don't know these details, you can't possibly make an objective decision about whether the company is making money and whether investing in the company's future is worthwhile.

A company's accounting department is the key source of its financial reports. This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called double-entry accounting, which requires a company to record resources and the assets it uses to get those resources. For example, if you buy a chair, you must spend another asset, such as cash. An entry in the double-entry accounting system shows both sides of that transaction — the cash account is reduced by the chair's price, and the furniture account value is increased by the chair's price.

This crucial method of accounting gives companies the ability to record and track business activity in a standardized way. Accounting methods are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry accounting, turn to Chapter 4.

Many people count on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:

Executives and managers: They need information to know how well the company is doing financially and to find out about problem areas so they can make changes to improve the company's performance.

Employees: They need to know how well they're meeting or exceeding their goals and where they need to improve. For example, if a salesperson has to make $50,000 in sales during the month, they need a financial report at the end of the month to gauge how well they did in meeting that goal. If they believe that they met the goal but the financial report doesn't show that they did, they must provide details to defend their production levels. Most salespeople are paid according to their sales production. Without financial reports, they'd have no idea what their compensation is based on.Employees also make career and retirement investment decisions based on the company's financial reports. If the reports are misleading or false, employees may lose most, if not all, of their 401(k) retirement savings, and their long-term financial futures may be at risk.

Creditors: They need to understand a company's financial results to determine whether to risk lending more money to the company and to find out whether the firm is meeting the minimum requirements of any loan programs that are already in place. To find out how creditors gauge whether a business meets their requirements, see Chapters 9and 12.If a firm's financial reports are false or misleading, creditors may loan money at an interest rate that doesn't truly reflect the risks they're taking. And by trusting the misleading information, they may miss out on a better opportunity.

Investors: They need information to judge whether a company is a good investment. If investors think that a company is on a growth path because of the financial information it reports, but those reports turn out to be false, investors can pay, big time. They may buy stock at inflated prices and risk the loss of capital as the truth comes out, or they may miss out on better investing opportunities.

Government agencies: These agencies need to be sure that companies comply with regulations set at the state and federal levels. They also need to be certain that companies accurately inform the public about their financial position.

Analysts: They need information to develop analytical reviews for clients who are considering the company for investments or additional loan funds.

Financial reporters: They need to provide accurate coverage of a company's operations to the general public, which helps make investors aware of the critical financial issues facing the company and any changes the company makes in its operations.