Financial Reporting Analysis – Introduction
Financial reporting analysis involves analyzing a company’s financial statements by gauging performance and making informed decisions based on quantitative considerations. There are two broad groups of people that conduct this type of analysis.
It is used by external stakeholders, primarily to understand the general health of an organization and to assess business value along with financial performance. Internal constituents find a use for it as a monitoring tool to manage finances.
Financial reporting analysis includes the study of a company’s balance sheet, income statement, or statement of cash flows to evaluate company performance or value. Several techniques such as horizontal, vertical, and ratio analysis, among others, are used by investors to build a more nuanced picture of a company’s overall financial and non-financial profile.
Now that we have a preliminary understanding of financial reporting analysis, let’s understand its significance, both in relation to providing stakeholders with a holistic picture of an organization as well as self-assessment to evaluate from within.
Financial Reporting Analysis – The Significance
Financial Reporting Analysis is a crucial activity both for internal constituents looking out from the inside and external stakeholders looking in from the outside. It allows companies to ensure compliance with various regulatory mandates and accounting standards and communicate essential data to stakeholders in an open and transparent fashion.
It supports better decision-making by tracking historical performance to identify key focus areas and produce forecasts and monitor various metrics that are key to the overall health of the organization. A more frequent cadence of analysis (from annual to quarterly, for example) can help organizations accurately draw a holistic picture of overall performance.
With all the open data at their disposal, a lot of possibilities for granular analysis and proactive strategy development exist. We will briefly touch upon 4 important use cases for organizations.
- Peer benchmarking – It enables companies to compare their output in key metrics against direct competitors in their industry to gauge relative performance and assess where they stand from an operational efficiency and profitability standpoint. One of the most important ratios for both companies and investors is the net profit margin or what is commonly called the bottom line. A quick comparison between two competitors can provide a lot of information to interested parties about financial performance.
- Analyzing trends – Companies and analysts can make use of financial reporting analysis to identify cyclical and seasonal trends in specific business processes to better understand the ebbs and flows of the cash flows of a business or product line. Seasonal trends in a business can be observed annually around the same period. For example, a consumer electronics company manufacturing air conditioners will see a surge in sales in the summer. Cyclical trends, on the other hand, are non-periodic and typically manifest themselves at the end of a business cycle. They are correlated with overall economic prosperity or contraction at any given point in time.
- Performance monitoring – Financial reporting analysis can be utilized to gauge and take stock of data relating to the financial performance of a company and to evaluate if numbers are where they need to be per past projections and forecasts. For example, a company wishing to launch a new product line will want to pay close attention to available capital and all the factors directly contributing to it.
- Raising capital – Companies that wish to raise external money may make use of financial reporting analysis to create accurate projections concerning future performance and build a persuasive story to attract financiers and improve funding prospects.
In the next section, we explore the various steps investors and analysts perform when conducting a thorough financial reporting analysis.
Financial Reporting Analysis – The Process
Financial Reporting Analysis has been defined by many as an art and can be a rather involved process with no defined system of going about it. Like with many things, it is a function of experience and seasoned managers, investors, and analysts collect industry information over time, allowing them to perform financial analysis of companies more thoroughly and swiftly.
We briefly list 10 steps that can be followed to conduct financial reporting analysis and provide a foundation for interested stakeholders to get started.
- Collecting data – Analysts and investors typically look through a company’s Balance Sheet, Cash Flow Statements, Income Statements, and Shareholders’ Equity Statements among other documents for a period of at least 3 years to understand its financial positions and past performance. This information is usually found in a company’s annual report or 10-K in the respective regulators’ databases. For example, if the company is domiciled in the US, one would find this information through the EDGAR system.
- Analyzing data – Once all the relevant data has been collected, it is scanned to detect any large or abnormal movements in specific line items from one year to the next. For example, if the revenues show a big jump or fall or if total fixed assets grew or fell substantially from one period to another, they are generally strong indications of a shift in the business and will need further investigation.
- Reviewing financial statement notes – These notes provide additional context and data to that found in the line items and can help put them in perspective for investors and analysts conducting financial reporting analysis.
- Examining the income statement – This is the profit and loss account and shows the company’s revenue and expenses in a certain period. Studying it thoroughly can help analysts identify trends over time and chart the trajectory of a company.
- Evaluating shareholder equity statements – Analysts may find themselves asking if a company has issued new shares or bought some back or if its retained earnings account has shrunk or grown. This can again point towards a variety of causes impacting a business and can be grounds for deeper analysis.
- Analyzing cash flow statement – This shows how changes in income and balance sheet accounts affect cash and cash equivalents, breaking the analysis down to financing, investing, and operating activities.
- Calculating financial ratios – Among the most used financial ratios by analysts and investors is the net profit margin, earnings per share, price-to-earnings ratio, debt-to-equity ratio, and return on equity. They are broadly categorized into 5 different types based on what they indicate and include leverage ratios, liquidity ratios, efficiency ratios, profitability ratios, and market value ratios.
- Collating competitor data – Gathering data about key competitors is critical to put all the data gathered in context and compare how performance has changed in relation to others in the same industry.
- Reviewing market data – Studying fluctuations in the stock prices of a company over time and analyzing metrics like price-to-earnings ratio as mentioned above can nudge analysts and investors to dive deeper into the data and further examine business operations.
- Making predictions and forecasts – Charting out the expected course of events relating to a particular business is a core skill for many analysts and investors who want to take future bets on an organization and they employ various tools and techniques to achieve this from simple moving averages to complex financial models.
In the next section, we take a brief look at 5 factors analysts and investors should be cognizant of when conducting financial reporting analysis.
Financial Reporting Analysis – 5 Things Every Analyst Must Know
Financial reporting analysis is a complex undertaking and there are certain factors that simply cannot be ignored when performing it. We list 5 such factors that analysts and investors need to be vigilant about to reach the right conclusions with their analyses.
- Broader industry economic characteristics cannot be neglected – it is essential to determine and understand the value chain of the industry in which a given company operates. This involves knowing the chain of activities involved in the production, manufacturing, and distribution of a company’s product or service offerings.
- Company strategy matters – It is important for financial reporting analysts to be aware of the nature of the product or service on offer, its profitability, uniqueness, brand loyalty, and cost controls in place. Additional factors that may be considered include how vertically integrated the business is, how geographically diverse the company and its products are and how diverse the industry itself is.
- Do not ignore potential threats and current profitability – While the most common tools at the disposal of investors and analysts have already been discussed at length, this is where they can add more value to their evaluation of a firm. When it comes to profitability, it is important to consider how profitable the company’s operations are in relation to its assets regardless of how they are financed. Also worth considering is profitability from an equity shareholder perspective. Disaggregating data points into primary impact factors is another skill that enables analysts to make more rigorous assessments and understand the numbers better.
- Accurate company valuations are imperative – Valuations form a key element in the repertoire of financial analysts as they provide visibility into the anticipated potential of a company and can affect perceptions and investment decisions. Perhaps the most common method of valuation is measuring discounted cash flows (DCF) to determine the value of an investment today based on how much money it will generate in the future, adjusted for the time value of money. Other techniques include using free cash flows, relative valuations or economic value added among others.
- Do not underestimate the power of forecasts – Reasonable assumptions about the future of an organization can be made based on analysis of the data it puts out along with relevant contextual information from external sources. It is critical for analysts and investors to know how these assumptions will impact funding as well as cash flows in order to make informed choices with regard to the company.
Financial Reporting Analysis – How IRIS CARBON® Can Help
With the advent of structured data reporting mandates for corporates across the globe, XBRL has emerged as the standard of choice for business reporting owing to its ability to enhance transparency and comparability of corporate data. Regulators in the US, the EU as well as Asia, and Africa have adopted it in some form or another.
Where external stakeholders may rely on a host of financial reporting analysis tools for conducting a thorough analysis of any public company, it’s often not the same for internal constituents in smaller enterprises, where financial reporting analysis can seem overwhelming and resource intensive.
Many of them choose to outsource the creation of their financial statements to an external software vendor. However, in most cases, there is no unified solution for financial reporting analysis in the same family of products. A product providing businesses with this capability can prove to be a critical tool at the disposal of FP&A teams in organizations.
At IRIS CARBON®, our unified suite of products and services not only aid companies in preparing annual financial reports in XBRL, but we also provide tools such as IRIS iConnect that can seamlessly integrate with the likes of MS Excel and aid companies to, perform comparative analyses and generate reports with charts for easy consumption.
Our suite of products has already delivered stellar results for companies across Europe and the USA. We are present in over 20 countries in the EU and have produced ESEF iXBRL reports for over 200 small and large organizations through the IRIS CARBON® platform.
In the US, we work with companies filing to the US SEC in iXBRL as well as utilities and energy companies filing to the FERC in XBRL. With close to two decades of experience in structured data reporting, we are well positioned to aid you in electronic data creation and analysis.