Who Is The Target Audience Of Financial Statements?

Whether a business is small or large, a single employee, or 1,000 employees, maintaining basic financial statements is vital to the business's operations and overall success.

While larger, publicly owned businesses have responsibilities to disclose financial data to shareholders through annual reporting, small businesses should also be keeping detailed financial records through financial statements, such as balance sheets, income statements, and cash flow statements, which are vitally important for any small business.

While the target audience for financial statements will vary based on size and type of business, these documents may be reviewed by a variety of people, including financial advisors, creditors, potential investors, business clients, bank managers, and even customers.

Financial statements are critically important, not only to the health of a business and its day-to-day operations, but can be used to grow the business, earn good credit terms, entice investors, and plan for the future. Therefore, it's imperative to maintain meticulous and accurate financial records through several key financial documents.

Who is the Target Audience of Financial Statements?

A big mistake that many sole proprietors and small business owners make is not taking the time to set up, maintain, and audit key financial statements, not realizing how useful and absolutely necessary these documents are in the course of doing business.  

In order for a business to grow, it is vital to form key partnerships with a variety of entities and individuals. Every business should meet with an independent consultant, whether an accountant, financial or small business advisor, several times a year. It is equally important to develop relationships with key suppliers, banks, and eventually potential investors. To do this, the business must maintain some specific financial statements as outlined below.

Key Types of Financial Statements

There are many types of financial statements used by companies, both large and small. Some are tailored specifically to a target audience, and others are simply a record of financial transactions, both withdrawals and deposits, and account balances. Here are some key documents that every business needs:

• Balance Sheet
• Income Statement
• Cash Flow Statement

While there are several other financial documents that larger, publicly-owned companies may use and other documents that growing businesses will find helpful in maintaining and reporting their financial position, these three documents are absolutely necessary for every business to maintain. Let's take a closer look at each one of these separately.

Balance Sheet

The first important financial document for any company is a balance sheet. While there may be some small differences in how an organization documents its information, there are several key components to a balance sheet that are included on each and every balance sheet.

• Assets - The first section on any balance sheet is company assets. Assets are considered anything of value a business owns. Several types of business assets are calculated on a balance sheet. They may be broken out into individual bullets or included in the larger sum of assets.
• Current assets - Assets that are readily available to the business or that can be easily converted into cash for use by the business.
• Cash on hand
• Accounts receivable
• Product inventory
• Fixed or noncurrent assets - Assets that are intended for long-term use and are of value but cannot be converted into quick cash for immediate use
• Business property
• Office furniture, computers, office machinery
• Tools, machinery, other equipment
• Intangible assets - While difficult to monetize, are also included as a section or a line item on a balance sheet under fixed or noncurrent assets.
• Trademarks
• Copyrights
• Brand recognition
• Liabilities - The next section of a balance sheet outlines the company's liabilities. Liabilities are defined as anything a business owes, both current and future.  Liabilities can be current or long term.
• Current liabilities - liabilities that are immediate or must be paid within a year
• Accounts payable - rent, utilities, insurance, etc
• Loan payments
• Employee salary
• Long-term liabilities - liabilities that exist but do not need to be paid off immediately or within a year
• Mortgage
• Bonds
• Pension liabilities
• Capital leases

The difference between current assets and current liabilities on a company's balance sheet is considered its working capital. 

Working capital can be viewed as the money that is available for day to day use in running the business.

It is the cash immediately available to meet business needs without liquidating any fixed assets.

• Owner's Equity - The third section of a company's balance sheet is owner's equity. The owner's equity is determined by subtracting the total of a company's liabilities from the total of its assets.  

Owner equity differs from working capital because both short and long-term liabilities are considered when calculating equity, as are fixed assets. A young company that has recently invested in equipment utilizing long-term payment options may have plenty of working capital but no equity due to the organization's long term liabilities.

Negative equity can be a warning sign that a company is floundering, but negative equity can also be expected at times, particularly as a company grows and expands.  As an organization begins experiencing rapid growth and customer demand, a significant percentage of profit must often be reinvested back into the company to purchase new equipment, larger production space, or other capital expenses. Due to this rapid growth and expansion, a temporary decrease in equity is expected, not an indicator of a company's failure or demise.

Income Statement

The next document that every small business should utilize is an income statement, which is also often called a profit and loss statement. An income statement reports a business' revenues, expenses, and overall profits for a specified period of time. It is an excellent tool to stay informed on the overall financial performance of the business.

While a balance sheet gives an overall snapshot of a company's general assets, liabilities, and equity as of a specific date, a profit and loss statement will drill down further; and outline the actual financial activities, both profit, and loss, occurring over a specified time frame. There are several types of income statements, as listed below.

• Single-step income statement - The single-step income statement is the most basic income statement used to reflect a business' financial activity for a specified period of time. It uses a simple formula of: Net Income = (revenue + gains) - (expenses + losses). The single statement lists all revenue, gains, expenses, and losses along with the end result net income.

The single-step income statement is appropriate for many small businesses with simple operations and few line items that can be easily reported using the basic net income formula.

• Multi-step income statement - The multi-step income statement is more complex than the single step. It uses three separate calculations to calculate the net income of a business ultimately. The three formulas used are:
• Gross Profit = net sales - cost of good sold
• Operating Income = gross profit - operating expenses
• Net Income = Operating Income + non-operating items

This type of income statement is used for larger businesses, particularly those that have several operational departments that are necessary for the business yet are not income-generating, such as customer service or other business operations. This type of statement is typically used by large, complex businesses, while the vast majority of small businesses and simple operations can utilize a single step formula.

Why Are Income Statements Important?

Income statements provide an overview of the profitability of a business. They can also help find inefficiencies within the company and determine where the business spends most of its money. Income statements are also used to help business owners make decisions about where to invest money in the business, for example, buying more efficient equipment, finding lower supply costs, or expanding a product line.

Most income statements use some or all of these common accounting components to determine overall profitability, expenses, and net income.

• Sales Revenue - any money derived from the sale of goods or services.
• Cost of Sold Goods - the cost that the business incurs to sell goods/services, such as operating costs, material costs, etc.
• Advertising Expenses - the cost of all advertising, print, online, TV & radio, etc.
• Administrative Expenses - administrative costs of running the business, such as rent, salaries, office supplies, etc.
• Depreciation Expenses - the cost of large ticket items, such as equipment, vehicles, etc., are typically spread out over the item's expected useful time.
• Pre-Tax Income
• Net Income - the total income after subtracting expenses

Cash Flow Statement

The cash flow statement shows exactly where and how money flows in and out of a business. It helps business owners and associates determine how well a company manages funds, how successful a business is in generating revenue and meeting its financial obligations.

Typically, cash flow statements itemize financial activity in three separate categories, including:

• Cash from operating activities
• Cash from investing activities
• Cash from financing activities

Monitoring the expenses and income that are generated through each of these categories is integral to the long-term success and health of both small and large businesses. Below is a description of how money flows in and out of a business in each of these categories.

Cash from Operating Activities

Cash flow from operating activities (CFO) is one of the most important measures of a business and its chances for long-term success. It depicts the path of money in and out of the business based on activities surrounding the core business, including the cost of manufacturing products and the profit from selling those products.

Here are more examples of funds that account for cash flow from operating activities:

• Salaries paid to employees
• Money spent with vendors
• Money from the sale of products or services
• Rent and utilities
• Interest payments
• Income tax payments.

Cash from Investing Activities

Investment activities can often lead to a large amount of money leaving a business, especially during a growth period. Investments are not only investments in securities, but also investments made into the long-term success of the business, such as:

• Purchasing manufacturing equipment
• Purchasing computers systems and operating programs
• Sale of equipment
• Purchase or sale of securities

Companies may often show more money leaving the business, especially when purchasing equipment and other high-dollar items. However, if manufacturing equipment installation results in higher production and, ultimately, higher sales, the increase in sales dollars will ultimately be reflected in cash flow for operating activities.

Cash from Financing Activities

Cash from financing activities is the money generated to fund the company, expressed through transactions involving debt, company equity, and stock dividends, if any.

• Purchase and sale of company stock
• Issuing bonds to investors wishing to buy into the business
• Money received through grants and business loans

The Target Audience for Financial Statements

Financial information is provided in different formats. In addition to the individual statements described above, many companies also produce a yearly report outlining all of the financial activities, which are available to the general public, as well as all pertinent stakeholders.

From financial statements such as yearly reports to balance sheets, income statements, and cash flow statements, there are a variety of entities and individuals who have a vested interest in reviewing these documents, including:

• Company executives - Company executives utilize these reports to determine how the business is running. By monitoring spending and comparing administrative and production costs, company executives can make decisions about how to manage the business, control production and administrative costs, and reduce any inefficiencies within the organization that increase spending.
• Financial advisors - Financial advisors, particularly those with experience with start-ups and small businesses, can obtain a wealth of information from financial statements. A financial advisor can help business owners decide how to improve performance and maximize profits by analyzing the data.

Financial advisors can take information from a company's financial statements and create accurate projections regarding the organization's financial health. They can help business owners find ways to lower production or administrative costs, invest their money, and protect business owners by identifying potential financial pitfalls and risks.

• Accountants - Whether a salaried employee or an outside accounting firm, accountants will help prepare and review the financial documents, verify their accuracy, and also use the information provided to create tax documents and file yearly or quarterly taxes.
• Current and potential vendors - Financial statements are a valuable tool for an organization when establishing a credit line and credit terms with potential vendors or improving current terms with partnered vendors. Vendors use financial documents to estimate the potential risk of extending credit to an organization and determine the company's ability to pay the debt on time.

When companies are in good financial shape, they are more likely to get better credit terms and higher credit limits. Building good working relationships with suppliers is one of the most critical aspects of creating a viable and successful business. Therefore, it is important that an organization prepares and provides potential vendors with the financial statements when completing a credit application. Business owners should also periodically connect with current vendors with whom they have less than ideal credit terms and use their financial documents and payment history to negotiate potentially better credit terms.

• Current and potential investors - There are several times during the life of a business where investors can be critical to the success of a business:
• In its infancy, when owners are attempting to get established, purchase equipment, rent office space, and begin operating successfully
• During any period of rapid growth that requires large expenditures, such as purchasing or renting larger warehouse or production space, buying capital equipment to increase production
• If and when a company decides to transition from a privately-owned organization to a publicly owned and traded entity.

Finding investors and raising capital is a necessary step for many businesses in their infancy or when experiencing rapid growth and expansion. Whether specifically targeting investment companies, building strategic partnerships within an industry, or seeking business partners to share in the risks and rewards, well prepared financial documents can be the difference between a company hearing yes or no when soliciting investors.

Items that should be part of an investment package provided to any potential investor or current investors that may want to increase their stake in the company include:

• Detailed financial documents, along with sales projections for the upcoming 12- 36 months
• A standard business plan outlining the goals of the company for both the short (3 - 12 months) and long term (12 - 36 months or more)
• Customers - While casual customers may not have any true interest in reading financial documents, most companies make their financial information available to customers by request. Typically in the form of a quarterly or yearly report, some companies actually mail this information to clients.

When security or longevity is important, such as the case of insurance companies, banks, and other financial institutions, the financial status of an organization can really make a difference to customers and potential customers. Additionally, for publicly owned companies, customers can use the information in the financial statements when considering buying stock or making other investments in the organization.

Red Flags in a Company's Financial Documents

While individual readers of a company's financial documents will be analyzing the data differently, depending on the scope of their interest, there are some red flags in financial documents that all are significant to everyone. Below are some examples of potential red flags that require additional research or explanation:

• High debt-to-equity ratio
• Downtrends in revenue
• Large uncategorized expenses listed
• Higher liabilities than assets
• Declining profit margin

While there are reasonable explanations for these conditions to exist temporarily, in every case, anyone with a vested interest in an organization should take the time to understand why the condition exists currently and how and when will the condition be rectified. Each of these conditions is further examined below.

High Debt-to-Equity Ratio

If a company has a high debt to equity ratio, it is using a higher amount of debt, through loans or other sources, to turn a profit. Companies utilize both equity and debt to fund daily operations.

When a company consistently uses more debt than equity to fund its business, it could be a red flag. Because of the expense of manufacturing, or the nature of the business, some industries naturally carry higher debt-to-equity ratios.  Some examples of industries that have high D/E ratios are:

• Telecommunications - Due to rapid increases in technology, telecom companies are always investing in research and development and rapidly manufacturing new phones and other telecom equipment. Equipment used in the industry is quite expensive, and continual manufacturing requires plenty of materials. Consequently, Telecom companies rely heavily on loans based on projected earnings, thus having a higher D/E ratio.
• Banks and other Financial Institutions - Due to the nature of the business, banks and other financial companies make their money by financing terms and providing loans. Therefore, they are consistently existing with a high D/E ratio, which is expected and acceptable within the industry.
• Utility companies - Due to the necessary infrastructure, utilities such as electric companies typically have a high D/E ratio. Establishing and maintaining power lines and grids is costly, requires trained employees, expensive equipment, and 24-hour a day coverage.

When reviewing debt-to-equity ratios, one should also consider if the company is expanding, adding a new product line, or experiencing rapid growth. This would also create a temporarily high D/E ratio, which is expected. However, a high D/E ratio is a concern if, when compared to other companies in the same industry, an organization consistently carries a higher D/E ratio than its competitors

If an organization's debt-to-equity ratio begins to climb while operating under normal conditions, or due to declines in sales, work stoppages, or slower production, there may be a cause for concern. Business owners should review processes and procedures to identify inefficiencies that may slow production or research buying trends that could negatively affect sales. Some restructuring, product development, or better advertising may be necessary to breathe new life into a stale business.

Downtrends in Revenue

Many organizations occasionally see downtrends in revenue, whether due to a decrease in consumer confidence in terms of:

• Spending,
• Time of year
• The overall financial climate at the moment  

All of this will cause a company to see a reduction in revenue or profit.

However, if sales or incoming revenue continue to remain flat, especially after consumer spending increases or sales are consistently low compared to prior year sales, this downtrend is a true concern. This is when an organization needs to regroup and determine the next steps, invest in more product development, expand their product offerings, or change their advertising processes in an attempt to revive the business and increase revenue.

Large Uncategorized Expenses

Every company experiences some miscellaneous spending here and there. Whether it's to cover a dinner expense when trying to sway an investor or some one-off purchase made in an emergency situation, uncategorized or miscellaneous spending will occur on occasion, with no cause for concern.

Miscellaneous charges should account for a very small percentage of spending since it is impossible to obtain useful information from this type of line item.

If a company consistently has high uncategorized expenses, it has no way to accurately determine where that money is going or how to fix the problem.  Miscellaneous line items can make it impossible for business owners to identify and correct operational inefficiencies.

In a worst-case scenario, these uncategorized expenses could be a red flag for potential embezzlement.

Higher Liabilities than Assets

When a business is new or growing and expanding rapidly, it will have, at times, higher liabilities than assets. While this is to be expected when a company is investing in new equipment, expanding a product line, or experiencing tremendous growth,  as time goes on, this situation should correct itself as profits increase.

However, if a company consistently operates with higher liabilities than assets, it signifies that the business cannot remain viable over time without significant change. This is a red flag that should signal owners or business advisors that a true overhaul of the business may be required to turn things around for the company.  

Declining Profit Margins

Declining profit margins can be a difficult problem to assess. First, depending on the competition in the marketplace, it may be necessary for a company to run its business with a very tight margin. However, this creates a situation where a company must exist on a shoestring budget, which doesn't allow much give or take. Any large, unexpected expense could be disastrous for companies that operate with super tight margins.

A good rule of thumb is to look at profit margins at competing companies, as direct competitors should have similar profit margins. If a company's margins are too low to remain viable, they may need to work with vendors and negotiate price breaks for supplies, better credit terms, and lower pricing.

Expanding a product line, adding service-based warranties or programs as add-ons for upselling, or adding an additional, complementary product line are all ways that companies have managed to overcome declining profit margins.

Knowledge is Power

Whether reading a financial document as a business partner, financial analyst or educated consumer, understanding an organization's financial state can be important. As a potential employee, it is vital to know the true financial state of a potential employer. As a consumer, it is equally important to select carefully, especially when making long-term investments, such as purchasing property, health services, or life insurance.

From a business perspective, maintaining accurate financial records and regularly reviewing them with a financial analyst or business partner can mean the difference between success and failure. It can be tempting, especially as a new business, to skip the tedious step of maintaining all necessary documentation. However, keeping accurate records is truly the lifeblood of maintaining and growing a successful business.