Scroll through the opening pages of a company annual report and you will find glossy pictures of the company’s best features, happy smiling customers and slightly awkwardly posed shots of the company’s key personnel.
Keep going through the marketing fluff and, hidden away much later on, you will find the bits that really matter - the numbers. Knowing how to read these numbers is a great addition to your investment knowledge.
There are three financial statements to understand – the profit and loss account, the balance sheet and the cash flow statement. Having a good look at what all the footnotes to the main text are hiding is also a good idea.
The profit and loss statement
Working down the page the profit and loss account will be something like this:
- revenue – the total value of the company’s sales during the period
- cost of sales – what it cost to make whatever the company sells
- revenue minus cost of sales = gross profit
- overheads – things such as sales and marketing, research and development
- gross profit minus overheads = operating profit
- finance costs – the costs associated with borrowing money
- operating profit minus finance costs = profit before tax
- profit after tax divided by number of shares = earnings per share
Earnings per share might be affected by more shares that have yet to be issued. If so, the profit will be divided by the new total number of shares to give diluted earnings per share.
Another item that could appear on this account is exceptionals - something that isn’t there every year, such as costs associated with relocation.
The balance sheet
The balance sheet is a snapshot of all the company’s assets and liabilities at a particular time. Assets minus liabilities gives the company’s net worth. Net worth is equal to shareholders’ equity, the amount of the business that the shareholders own.
Assets can be divided into two types. Fixed assets are things that will be around for a long time such as buildings and computer equipment and intangible items such as trademarks. Current assets are things that will not last as long such as stock and cash.
Liabilities also fall into two categories depending on when they need to be repaid. If the money needs to be paid within the next year it is a current liability. If not, it is a long-term liability.
Also in this section will be details of all the shares in circulation and any money that has been retained and not returned to shareholders in the form of dividends.
Cash flow report
The cash flow statement will show cash that has come in or gone out in the relevant period but not count things bought or sold on credit where the money has not actually been paid out or received. There are three main areas in this statement: operations, and investing and financing activities.
The figure for operations equates to the profit before tax but adjusted to take account of all the items that were not actually paid for in the period. So some items from the previous period may well have been paid for in this period and some that have been accounted for in this period won’t actually be paid out until the next statement.
The abstract items of depreciation and amortisation are often added back in here as well because they are not a cash movement. Depreciation is loss of value over time of things such as machinery. Amortisation is the cost of intangible assets such as trademarks.
The investing statement will likely have a negative final figure as chances are the company will have invested in things such as equipment. Other items that may show up here include dividends and interest earned from investments.
Financing will also probably have a negative total as this section is where the company records items such as money paid to shareholders and interest paid on loans. If the company has raised money in the period, say from a new share issue, this will show as a cash inflow here.
Return on equity
This is an important figure for investors as it shows how successfully a company is using the assets at its disposal. It is calculated by dividing net income by shareholders’ equity. You can then compare this figure to that of other firms in the same line of business to see how well the company is doing.
Debt to equity ratio
Companies source funding from shareholders and from borrowing. This figure shows how well the company would do if, for some reason, it had to pay back all its borrowing in one go. It is calculated by dividing total liabilities by total shareholders’ funds.
Having high levels of debt compared with shareholders’ funds is known as being highly geared or highly leveraged. This level will vary from industry to industry.
This is calculated simply by dividing current assets by current liabilities. If the figure is greater than one it means that a company could pay back all its short-term debt without having to source additional finance.
EBITDA does not appear in all accounts and is not an official accounting standard but is a recognised measure of how healthy a company is. EBITDA stands for earnings before interest, tax, depreciation and amortisation. It can be calculated by adding interest, tax, depreciation and amortisation to net income.
Different sectors may have additional information in their accounts. For example, insurance companies will have the combined operating ratio, which is the sum of the net claims, commissions and expenses divided by net earned premium. A COR of less than 100% shows profitable underwriting.
Statement of intent
The chairman’s statement in a report can be an interesting and informative read and interpreting the use of words such as challenging and difficult can give you insights into the health of the company.
Research by the UK regulator the Financial Reporting Council (FRC) has shown what people expect to see in company reports and would like to see.
Most investors want the company to include:
- What it does and where it sits in the value chain
- Key divisions, their contribution and legal structure
- Key markets and market segments
- Its competitive advantage
- Key inputs (assets and liabilities, relationships and resources) and how they are maintained/enhanced
- Key revenue and profit drivers
- Value created for other stakeholders that supports economic value generation
- Statistics to indicate relative importance of elements
Many investors want the company to include:
- Direct threats
- Market share
Some investors want the company to include:
- Culture and values
- SWOT (strengths, weaknesses, opportunities, threats) analysis
- Investment plans
- How the business model is likely to evolve
- Cash flow
- Capital and assets allocated to business
- Return on investment, return on capital employed, return on assets
Regulators often make changes to the way companies are expected to report. These rules are known as generally accepted accounting principles (GAAP). In the US, new Financial Accounting Standard Board rules will affect the way that companies record revenue and report the value of leases.
The US Public Company Accounting Oversight Board (PCAOB) has also brought in new rules to give more information to investors. Critical audit matters will have to be flagged up in auditors’ reports.
The PCAOB describes these as “matters arising from the audit that involved especially challenging, subjective, or complex auditor judgment”.
It gives examples of “significant management estimates and judgments made in preparing the financial statements; areas of high financial statement and audit risk; significant unusual transactions; and other significant changes in the financial statements”.
In the UK, certain financial companies will fall under the scope of the new non-financial reporting directive that will require them to add non-financial matters to their strategic reports.
Could do better
Companies knowing what should go in their reports and actually putting that information into the report can be slightly different matters. Regulator the Financial Reporting Council in its recent review of 203 sets of interim and annual accounts advised 60 companies that their accounts were not up to scratch.
The FRC found that while reporting by large listed companies was generally good, detailed explanations and clarity could still be better. The most frequent issues identified were with:
- judgements and estimates
- strategic report
- accounting policies
- business combinations
- alternative performance measures
- impairment of assets
- financial instruments: disclosures
- fair value measurement
- statement of cash flows
Paul George, the FRC’s executive director for corporate governance and reporting, said: “High quality and transparent reporting are fundamental to building trust and to the long-term success of UK companies and the wider economy.”
When financial accounting goes bad
Enforcement is an integral part of the FRC’s work and in the period between July 2016 and August 2017 it concluded eight investigations. Sanctions included exclusions from professional bodies for up to 10 years, fines of up to £100,000 and, payment of legal costs.
However, the FRC’s scope is limited to directors who are members of certain professional bodies. In the absence of legislation to enable it to investigate all directors, it is working with the Financial Conduct Authority and the Insolvency Service, both of which have powers to investigate and sanction directors.
When things go really bad with company accounts directors can end up in court. Three former directors of Tesco are currently on trial at Southwark Crown Court charged with false accounting and fraud by abuse of position. All three deny the charges.
Tesco’s profits to the end of August 2014 were overstated by £326m.Tesco said at the time: “During its final preparations for the forthcoming interim results, Tesco has identified an overstatement of its expected profit for the half year, principally due to the accelerated recognition of commercial income and delayed accrual of costs.”
This basically means that money due in was accounted for too early and money going out kept in the figures. For this creative accounting Tesco has paid an SFO fine of £129m and has given £85m compensation to those who bought shares and bonds in the three weeks between the misleading trading update and the company informing the market of the error.
Ironically, someone famed for his investment nous was one of those affected by the Tesco accounting mess - Warren Buffett lost some $444m on his investment in the supermarket.
In his 2015 letter to Berkshire Hathaway shareholders he said: "During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.”
Buffett’s way of looking at a company is known as fundamental analysis. He has said: “I realised that technical analysis didn't work when I turned the chart upside down and didn't get a different answer.”
Fundamental analysis involves working out the intrinsic value of a share from examining company financial data and long-term prospects. If the market price of the share is less than its intrinsic value, it is an attractive stock.
Once is enough
Since 2014 UK listed companies have not had to produce quarterly reports but many have continued to do so. Critics of quarterly reporting say it encourages short-term thinking with companies running the business to hit quarterly targets.
Trade body the Investment Association has been campaigning to stop quarterly reporting and says that companies are starting to get the message with over 40% of FTSE 100 companies and over 60% of FTSE 250 companies no longer issuing quarterly reports to shareholders.
The number of FTSE 100 companies reporting quarterly has fallen 19% in the past year, with 43 companies no longer doing it. Quarterly reporting among FTSE 250 companies is down 25%, with 167 companies having abandoned it. Companies which have stopped quarterly reporting recently include Schroders, Legal and General, Centrica, Diageo and Aviva.
Listed companies in the US still have to publish quarterly reports.
So when you look through that company report by all means admire the marketing fluff and laugh at the slightly awkwardly posed staff pictures but perhaps do that after having had a good read of the important stuff at the end first.