Investors want more and better financial information from companies. One can say quality financial reports offer them better insights, leading to more effective financial analysis.
However, some companies’ financial statements are designed to hide information. Investors should avoid organizations that lack transparency in their financial reports because companies with complex financial and corporate structures can be associated with a higher level of risk where investments are concerned.
High-quality financial accounts can be described as transparent. One of the most commonly used words among business people is disruptive innovation. A company’s overall risk and financial leverage are the same for both companies. Also, let’s assume that both companies earn the same amount of money and grow their wealth at the same rate. On the other hand, Company X is a single-business concern with transparent financial reports. While Company Y has many enterprises and subsidiaries, its financials are far more complicated.
Which one is the better investment? One can assume that the market will place a higher value on Company X. Company Y’s complicated financial filings can lead to a drop in its value.
There is a simple reason for this: investors are less confident when they have less information. Investors can never be sure of a company’s genuine fundamentals and actual risk if its financial statements are opaque. Consider how an organization’s investment strategy affects its growth potential. If a company’s investments are disguised behind holding companies, it’s impossible to assess how well they’ve performed.
Additionally, a company’s degree of debt may be obscured by a lack of openness. Investors cannot assess their risk of bankruptcy if a company conceals its debt.
Financial scandals have shown that managers can use flimsy financial reporting and complex organizational structures to hide bad information. When there is a general lack of openness, bad things can happen.
Transparency is a challenge for certain businesses, but why?
A wide range of factors contributes to incomplete or incorrect financial reporting. A small but hazardous fraction of organizations actively attempt to mislead their customers. “Other businesses disseminate information that may be incorrect, yet it complies with legal requirements.
Incentives for key personnel to misreport critical facts were boosted by the rise in stock option pay. Pro forma profits and comparable methodologies, including hypothetical transactions, have become increasingly important to companies.
Certain companies find it difficult to provide financial information by accounting standards that are ambiguous and ever-changing.
Complexity increases obstacles
Some companies are more complicated than others. It’s not uncommon for someone to run many enterprises with little in common. Analyzing the finances of a company like Netflix (NFLX), a pure-play internet entertainment service, is more complex than doing it for a conglomerate like General Electric (GE).
Companies’ organization of their new enterprises increases complexity while decreasing transparency when they enter new markets or business ventures. It is easier to examine and value a firm that separates each of its businesses where all can be combined into a single organization.
Meanwhile, investors may be perplexed by the growing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements, and new tax vehicles.
A company’s ability to give investors crucial information is more important than the cause of poor transparency, which is less relevant. Financial statements that investors don’t trust or don’t understand misrepresent a company’s actual performance and real worth.
Investors should look for transparency and ease of use. Investors can have more faith in a company’s fundamentals if it discloses more information about where it’s earning profit and how it spends its resources.
A line-of-sight picture of the company’s growth drivers is much more valuable than a traditional financial report. Investing in stocks is safer when the information is open and easy to understand. It is less likely that a negative experience will arise for the investor in this manner.
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