It recreates all that is on your HDD including files settings and the operating System eg windows XP.
The file is only as big as the information requirements which is less than the HDD size which is occupied by data. So if your HDD is eg 100GB and its only 25GB used then it will only image the used parts. There is some compression to save space but you can elect to compress at a higher level to save more space. click here
The best way in the longer term is to get an external HDD and back up onto that rather than your internal HDD. In the event of a HDD you are protected because everything is saved for you.
Not sure what you want to do a reformat for but yes it will wipe off your HDD so a re-install of everything will be required.