Reproduced from Investors Chronicle of April 3 1987
We don’t expect you all to do your own number-crunching. But even novices may find it useful to know what the basic figures in company accounts represent.
Boring, complex and backward looking. That is a common attitude to company accounts — and in some respects it is pretty fair. They are stuffed with accountants’ jargon; they arrive about three months out of date; and, in any case, the bulk of the information they contain tells you very little about the company’s future — just about its past.
So why bother? The report can reveal weak spots (or plus points) that do not emerge from the preliminary results. If a company is piling up massive debts it should be detectable from its balance sheet. So, if you are anxious to check up on a company’s health — or looking for a cash-rich shell or an asset-stuffed takeover target — there is really no substitute for reading the accounts.
Reading order is a matter of taste. Many analysts start with the bare figures before moving back to the verbiage. Others flick backwards and forwards trying to piece the story together. But if you are a real “beginner” you need to know first which bits tell you what. Then you can decide on your own reading order.
Let us start with the “chairman’s statement”. Usually this is the easiest part of the report to read. It will tell you what sort of year the company has had and it will often give an indication of what the future holds. Note, however, that his remarks may well be very selective. There is no guarantee that this statement will tell you all that is going on. And long chatty statements are not necessarily more informative than terse ones.
The next part of the document — the “directors’ report” — should be more reliable, since its contents are largely determined by law. It explains the company’s trading activities and lists any acquisitions or disposals or changes in the company’s structure. It will tell you the names of shareholders whose stakes exceed 5% of the company, which can be an indication of how City investors feel about the company. It will also tell you of any changes to the list of directors or their holdings in the company. It is always useful to know whether the men who run the company have a significant stake in it.
Then find and read the “auditors’ report”. Normally this says very pithily that the accounts give a “true and fair view” of the state of affairs. If not, tread carefully! Qualified accounts frequently spell trouble for shareholders and creditors — though sometimes the qualification is just a minor procedural niggle. Different forms of words convey different degrees of worry to the cognoscenti. But if the auditors’ report covers several pages and starts off by saying that the auditors “are unable to form an opinion as to whether the accounts show a true and fair view,” watch out!
Also check the accounting policies which are usually at the beginning of the “notes on the accounts”. If policies have been changed there is usually a good reason — but even so, the change may put an artificial gloss on the figures.
Once the background information is complete it is time for the nitty gritty — “the accounts” themselves. As an example we have taken the recently produced Body Shop accounts which are fairly straightforward and clearly laid out.
The accounts have two main parts:
(a) The Profit & Loss Account, which tells you about trading during the company’s latest financial year.
(b) The Balance Sheet which reflects the company’s overall finances at the end of that year, and shows how they have changed because of the latest year’s developments.
The two are complementary.
First turn to the “Profit & Loss” account. Once you have cut your way through the jargon this can be dealt with fairly quickly. It starts with turnover which usually just means sales. But in this case it is a bit tricky since Body Shop is mainly franchises. As a result, turnover is made up of sales at retail prices to company owned shops and sales at wholesale prices to franchise shops. There is also a small amount coming in from franchise fees.
Turnover is then analysed in the footnote by geographical market. Body Shop still gets almost 80% of its sales from the UK, even though overseas markets could be the key to future profits’ growth.
They have then subtracted the cost of sales (that is direct costs such as merchandise, sales-force, electricity, rent and rates) to get the first measure of profit (ie gross profit). Next they subtract the business’ indirect costs (distribution and administration). The figure arrived at (£3,415,622) is often known as trading or operating profit. After the trading side comes the money side — in this case rent and bank interest received minus interest payable.
That takes you down to the pre-tax profit — the figure that hits the headlines and gets compared from year to year. It is worth a dive into the footnotes at this point. Note 5 states what has been charged in fees and depreciation (a notional charge for the gradual loss of value of an asset as it approaches obsolescence) and what has been credited from sale of assets. It also tells you what the directors are paid and gives a separate figure for the chairman and highest paid director.
Clearly tax has got to be subtracted from this figure. Companies pay a percentage of pre-tax profits in tax, so the higher the profit, the higher the tax paid out. In Body Shop’s case that means an increase from £908,466 to £1,371,964. (Tax allowances used to complicate things, but they are being phased out.) After tax, they have knocked off the profits that are due to minority interests, ie a subsidiary’s other shareholders.
Now at last you are down to the profit that can be distributed to shareholders or ploughed back into the company for future growth. Body Shop is paying out £300,000 to shareholders (double the 1985 figure). But the bulk of the money, £1,761,761, has been transferred to reserves to finance future growth.
Now tackle the “Balance Sheet”. This is in effect a snapshot of the company and its assets and liabilities on the last day of its financial year. It explains what the company owns and what it owes and then it tells you where all its capital came from. It is useful provided you realise (a) that some companies’ balance sheets look much more reassuring at some times of the year than at others, and (b) that companies have been known deliberately to tidy up their balance sheets at the end of the year.
Often, as in Body Shop’s case, there are two balance sheets. One for the parent company; the other — the more interesting from the investor’s point of view — is “consolidated” for the entire group.
First, what does the company own? Fixed assets such as property and machines are listed first. An important point to watch for is the date at which fixed assets are valued. If it was a long time ago inflation has probably increased their worth. Not, though, in this case. You can see from the directors’ report that book value is thought to approximate to market value.
Next comes stocks, which include both finished goods and raw materials. These have doubled over the year. Flip forward to Note 13 and you will see that the value of finished goods at around £4m greatly outweighs the raw materials which are worth £228,000. Often a high level of stocks of finished goods is a bad sign. It can mean that they are piling up because they are not being sold and will eventually have to be “written down” and flogged off cheap. But Body Shop’s balance sheet was produced on September 30 — just before the company’s busiest trading period. So a likely explanation is that the company was stockpiling finished goods ready to supply them to the shops. The fact that they have doubled in a year need not worry you either. Turnover also doubled last year. You would expect this kind of rise in a fast growing group — though it would be worrying in a sluggish one.
After current assets (which are made up of stocks, sums owed by debtors and short term cash) comes a figure for creditors — all the money due to be paid out during one year. This has gone up steeply from £2,889,484 in 1985 to £6,471,486 in 1986. Consult Note 15 and you will see that the major causes are an increase in bank overdraft, trade creditors and corporation tax. None of these are surprising in a growing business.
But when a company is trading badly, it is worth looking carefully at these figures. The grater the shortfall between its liabilities and its realisable assets, the more problem a company will have in paying debts as they fall due.
What else does the company owe? There are longer term debts that have increased a little from £92,684 to £143,090. It has decided also to set aside some money for future costs — in this instance a future tax bill. This contingent liability provision can be useful as it will give you warning on whether there are any nasty surprises, such as a law suit, tucked around the corner.
The balance sheet clearly has to balance. And the bottom half shows where all its finances come from. There are three potential sources: shareholders, moneylenders and financiers and the business itself. In this case there is £500,000 of shareholders’ capital but the bulk of the money comes from the profit & loss account (or reserve, as it is sometimes called). That is the profit that the company puts by year on year. So it includes the £1,761,761 mentioned in the profit & loss account as being transferred to reserves.
Share capital, of course, belongs to the shareholders. But so, in fact, do the reserves, since this is profit which the company chooses not to distribute. Lump together these items and you get shareholders’ funds. With this you can calculate the borrowing or “gearing” ratio.
First version of this is gross debt to shareholders’ funds — that is, all the company’s borrowings (long and short term) as a percentage of shareholders’ funds. Second version is net debt to shareholders’ funds, which is all borrowings minus any cash in the bank (or near cash, eg gilts) as a percentage of shareholders’ funds. These ratios give a good indication of where a company has overstretched itself (the term “gearing” has other meanings as well, so always check which one you are talking about).
You sometimes need to dive into the balance sheet footnotes to sort out the precise borrowing figures. In Body Shop’s case, gross debt is £1.2m and net debt is £0.2m, giving gearing rates of 35% and 5% respectively. There should be no strain on the company with figures that low.
But be a bit careful here. Some businesses — such as airlines — normally operate with higher borrowings than others. High gearing can be a killer when times are tough, but acts like a turbo-charger when profits are rising.
The final section of the accounts in this “statement of source and application of funds”. This explains the cash flow of the company and often gives a clearer picture of how the business has been trading. It shows where funds have come from over the year — profits, depreciation and sale of fixed assets — and where it went to (eg tax, dividends, new plant, stocks and paying off creditors).
