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.