Much of the analysis of suitable investments for both professionals and private investors starts with the company’s annual report and accounts, and most of the ratios are calculated from figures taken from the annual report. Most companies will be happy to forward a copy on request and large numbers of them are available on the internet from Company Annual Reports On-Line (CAROL). Quite often, companies put their accounts on their websites, and they can usually be found on the investor home page.
Annual reports and accounts are formidable documents apparently designed to ward off insomnia in all but the most dedicated. But you don’t get owt for nowt – investing your time before investing your money reduces the chances of doing something spectacularly silly. So it is worth learning a little of the meanings behind the figures, and the conventions used to prepare them. For a true understanding of a business and how the company fares one really needs to talk to production foremen, sales staff, van drivers, internal auditors, purchasing managers and the finance director to supplement the picture from the published figures. Unhappily this is not open to investors, though it would be for stockbrokers’ analysts if they bothered to avail themselves of it.
The first rule to remember is not to be taken in by the spurious accuracy of having it all set down in precise-looking numbers. Everything in the annual report is the result of approximation, estimation, interpretation or guess. Accounting standards may limit the range of flexibility but the company still has scope for a pretty fair range of subjective assessment. That is in part because the rules themselves have to apply to a wide range of types and size of business and an enormous range of circumstances. As even the Accounting Standards Board conceded many years ago, corporate accounts can be relevant or comparable, but not both. It has in the main gone for relevance (the figures are tailored more to produce a fair picture of the business) at the expense of producing readily comparable accounts, which means investors get a better picture of the business itself but must put in some extra work to try and measure one business against another.
The second rule is that the purpose of accounts is to demonstrate that the business is being run honestly and the investors’ cash is not being embezzled. There is no intention to demonstrate competence, much less efficiency, though that is what investors need. In the absence of direct hints about how clever the managers are, investors need to dig into the annual report to deduce it from the available information.
It is partly to help that process that the accounting profession has for decades gone way beyond the demands of the Companies Acts in the amount of disclosure. The theory is that if all possible information is there, crooks and fools will have nowhere to hide. On the other hand, Britain is approaching the United States in the size of corporate documents and few can sift relevance from the mountain of figures. Some of it is unquestionably helpful in getting down to the details of how the numbers relate, but that usually acts as a substitute for finding just what makes a business tick.
A company’s annual report and accounts may have plenty of material for the careful calculations of stockbrokers’ analysts but much of it will be incomprehensible, boring or irrelevant to most investors. Nevertheless the document does contain the occasional gems that indicate where the company is going and whether it is headed for riches or the knackers’ yard.
Relying on the auditors too heavily is a mistake. They are accountants, nominally appointed by shareholders but in practice by directors, who are supposed to take an outsider’s dispassionate view of the figures and to see that they have some relation to reality. Their main criteria are supposed to be derived from the requirement that the accounts represent a true and fair view, but increasingly they prefer the less contentious approach of saying the figures have been compiled in line with the rules. Even when they are conscientious, independent and rigorous, auditors are governed by the same uncertainties in the figures as the company itself, and in any case they cannot possibly check everything. As they themselves keep saying, they are guard-dogs, not bloodhounds – in other words they are there to check the figures add up and the stocks really are in the warehouse but do not see their job as hunting through the business for signs of fraud or even incompetence. That is why auditors clearly say at the end of the report it was the directors who prepared the accounts and who must take responsibility for them.
Such statements are also an attempt at a pre-emptive defence against litigation. When companies go under or are found to have been subject to massive fraud, creditors sue auditors because they have large professional indemnity insurance, rather than directors who may have carefully salted money away in overseas trusts or their spouses’ names and therefore seem to be people of no substance. Directors are, however, responsible both in law and in fact for running the company, and shareholders should resist pressures to reduce their liability no matter how worthy the cause appears to be.
Another thing to remember is that accounts represent the past. They will not therefore necessarily give an accurate picture of where the company is now, much less where it will be in the future, especially in fast-moving trades or changing economies. Accounts are prepared on a ‘going-concern’ basis, which means, among other things, that assets are valued not by how much they would fetch in a break-up but at their worth to the business.
None of this is intended to suggest that accounts are useless or misleading, merely that they need interpretation, are imprecise and represent the past. That means a little more work in trying to evaluate just what they really do suggest.
First, some conventions. Like the government, companies generally do not stick to the calendar year. Financial years start at any time, sometimes not even at the beginning of a month. There may be nothing sinister in this. Financial years start when the company was originally registered and it could be that it has just stuck with it. Some businesses reckon their sales are seasonal and set the financial year so the second half gets the benefit of the upturn.
Any number in parentheses is a negative. So, at the profit level of the accounts, £12.8 million indicates a profit but (£385,000) shows a loss. The numbers in the main pages of the accounts are mostly sums of various groups of numbers that are then shown in greater detail in the notes – there is normally a little number next to each line to show which note relates to it. It is also worth remembering that many of the numbers in the report are a bit barren on their own and have a far greater significance when related to other numbers in the accounts, set against previous years or by comparison with other businesses.
The main items in the document are the directors’ report, the profit and loss account, and the balance sheet. In addition there are the extensive notes, which are supposed to amplify or explain the figures; the source and application of funds, which show where the company got its cash and how the money was used; and the auditors’ report.
Chairman’s and directors’ report
Right at the front is a brief word from the chairman and the directors’ report. These should say what the company does and sum up significant highlights of the year just completed, possibly with some comments on the performance and how the figures should be interpreted. There is often a word about prospects, which is only fair considering most reports are produced several months into the next financial year, but seldom give more than a cursory suggestion. The usual formula is something like, ‘Despite the difficult financial circumstances we hope to continue developing the company and hope for further improvement in the results for the current year.’ If the results turn out worse, shareholders cannot sue for misrepresentation even on that small scale and, to be fair, even three months into a year may give a misleading picture of the results for the whole 12 months. One has therefore to learn to read between the lines and see what the phrases indicate and what the report is hinting at. Some do try to be as explicit as circumstances permit, and so can offer a veiled message.
Most of this is extremely boring and can safely be ignored as routine prescribed by the laws and accounting standards. Just occasionally, however, a company reckons the standard rules would produce nonsense and, rather than mislead, it intends to depart from the normal presentation. The report then should explain what standard is being breached and why. The explanation of this may not always be the most lucid prose and is not primarily aimed at the layperson, but a bit of careful attention will usually unravel it. If the auditors reckon it is a bit of flummery or specious excuse they will comment on it in their report.
Profit and loss account
The profit and loss account starts by showing the company’s trading over the previous financial year. That shows turnover, which just means sales and sometimes is actually labelled so. Drinks companies sometimes then take off excise taxes to show net sales value. One can then see how this latest year compared with the previous one. Even if it looks healthy it is probably wise to flip to the note associated with the figure and see if there are breakdowns. Some companies show the sales by product, by geographical area, by market sector and so on. This will show whether there are any peculiarities, like one product supporting the sagging rest or one geographical area turning distinctly dodgy. If there is anything like that, turn to the chairman’s and directors’ reports to see if there is any explanation. The answer may be something simple like an acquisition or a disposal. If there is no explanation, such distortions or odd figures should prompt questions and trigger caution.
Next are the operating costs of running the company including everything from stationery to wages, which are often broken down into major components such as cost of manufacturing, distribution, administration, and research and development. These can sometimes suggest questions, such as: why is administration so expensive, or why has the company been cutting back on research for several years? When the cost of sales is deducted from the total turnover figure, the result is the operating profit.
In larger companies you then get a variety of other incomes such as money paid to the parent company by subsidiaries, or occasionally the other way, and some exceptional items that are not the normal part of the company’s trading operations. A business has to pay interest on money it has borrowed. Any sharp movement in interest out or in that is out of line with prevailing interest rates should prompt searches in the notes and statements for explanations. It could be borrowings for acquisitions or for a large redundancy programme.
When the operating costs and other incomes have been accounted for, what is left is the pre-tax profit, which is the figure normally used in newspaper accounts of results. Taking off Corporation Tax and dividend payments leaves retained profit, which the business is planning to reinvest.
Accounting standards say exceptional items such as profit from the sale of an office building or the cost of a major reorganization and redundancy of many employees, have to be separated out.
The other items are fairly straightforward. The profit and loss table shows the amount being paid to shareholders in dividends, sometimes with preference shares separated out. Anything left after that is transferred to reserves. This does not mean it goes into the company coffers, and the term is confusing, so some companies have opted instead to call the amount ‘retained profits’ or, to be even more explanatory, something like ‘profits retained in the business’. This is the money that builds the company. It goes into buying machinery, factories or raw materials, or financing work in progress. Some companies have starved themselves of this vital reinvestment because institutional shareholders demand a growing dividend cheque every year even if that means depriving the enterprise of cash – if the business suffers they will just ditch the shares and move on to another company.
There is nothing in the accounts that would suggest, for instance, a good start to the year but the whole business falling out of bed in its last three months with plunging sales and profits. All of that should be mentioned in the reports from chairman and directors with explanations as to why it happened and what they are doing about it.
A cliché is to talk about the bottom line, which is reckoned to come from the accounts. In fact the bottom line of the profit and loss account, after the retained profits figure, is usually the earnings per share. Dividing the share price by this figure provides the P/E ratio, or to be precise the historic P/E.
While profit and loss accounts show an accumulation of transactions over the whole financial year, the balance sheet is the picture (traditionally called a ‘snapshot’ to emphasize how briefly relevant it is) of the financial position and assets on the last day of a company’s financial year. Everything it owns or is owed on that day is shown under a range of headings. By the time shareholders see the totals, the figures are largely irrelevant because in the intervening months everything could have changed.
The figures are, as with much else in the accounts, open to a degree of flexibility. For instance, valuations of assets are fairly subjective and depend on the purpose for which the figure is being prepared. A machine tool may be vital for the company but would fetch little if the liquidator had to break up the assets. Setting a price on patents, trademarks or brand names is even dodgier and there have been years of arguments about the true valuation of such intangible assets. The physical assets and stocks are often shown at cost, but inflation will have eroded that even if other factors have not altered the valuation. Similarly, land values can move sharply with the vagaries of the economy and the property market.
What the accounts will show is the depreciation reducing the worth of assets. The notes and accounting policies usually elaborate on this, but it is normal for machinery to be written down by a fixed amount each year – straight-line depreciation. Clearly that leaves ample room for a bit of a nudge or window-dressing by adjusting valuations or bringing forward some items and delaying others, to give the total figure the company wants to project. The snapshot may therefore be wholly atypical of the state of its finances on any other day of the year. Despite that, it gives a hint of the financial health of the business, all the more so since the range of manipulations – short of outright fraud – is limited for a number of reasons including accounting standards and the need to be reasonably consistent with the previous years.
In the list of things the company owns the first heading is fixed assets. This comprises things that have been and are likely to continue as long-term investments. So it includes things like factories and equipment, office blocks and the like. Lorries are also included under this heading, probably for want of a better place to put them. The value is normally in there at cost or what they would sell for, or some formula.
Then come investments in other companies. Then there are current assets, which covers the more mobile, changing things like stocks of raw materials and finished products in the warehouse, money owed by customers, and money in the bank.
After that comes a list of the company’s debts. First there are current liabilities, or creditors expecting to be paid in under a year. This includes trade creditors (suppliers of goods and services who have not yet been paid), money borrowed short term, the money set aside for the proposed dividend, and the Corporation Tax to be paid on the profits. The total is then deducted from the current assets to show the net figure. This is sometimes called ‘working capital’.
Longer-term debt includes things like a term-loan from the bank and provisions for known spending such as restructuring the business, moving the factory or the feared outcome of a legal case. Taking the short- and long-term liabilities from the assets produces the net asset figure.
Once again, there should be comparison not only with the previous year, which most companies provide, but also with the previous five years. Combining the current figure with previous years’ and knowing something about the norms in that industry should provide a pretty good measure of the company’s financial health.
Cash flow, or flow of funds, or source and application of funds statements are, as the names suggest, a supplementary indication of how the money flows in from profits and investments, and goes out again for tax, dividends and the like. In addition it gives the figures for repayment of capital – redeeming a debenture, for instance – or finance in from raising further capital. There is little point in making a profit if the business just runs out of cash, and this is where the warning should show.
The final figure of the statement shows the growth or decrease in the company’s funds during the year. That is a fairly good indication of how successfully it has been managed.
The auditors’ report is normally a pretty routine affair, saying the company has abided by the accounting standards, Companies Acts requirements and other rules; that the directors are responsible for the accounts and the auditors merely take samples and tests as required by the Auditing Practices Board; and that as far as they can tell the accounts represent a true and fair account of the state of play. Just occasionally it is a qualified report.
In essence there are two sorts of qualification, as a result of uncertainty or from disagreement with the way directors treat some item. The effect may be much the same but the message is signalled in different ways.
If the uncertainty is big enough to mention but not fundamental to the business, the auditors normally say that, subject to the specific doubts, which they will normally spell out, the accounts are all right. That may just be awaiting the outcome of a court action and hence are inherently uncertain, but it could also say the auditors could not tell if proper accounts had been kept in one part of the business.
Sometimes it is a straight disagreement about the treatment of an item. Once again, if it is a biggish number in the context of the accounts but not serious enough to undermine the survival of the organization, the auditors normally say it is all true and fair except for the specified item. The auditors may, for instance, say a debt in the balance sheet is not recoverable despite all the directors’ optimism.
On a few rare occasions the split between the board and the auditors is so serious, or the auditors have stumbled on something so crucial to the company’s viability, that a more serious warning is inserted into the accounts. If the doubts about record-keeping or the reliability of information generally is so great that the auditors have serious doubts about the whole thing, they will say they could not discover whether the stocks are present or the sales are as stated; they may say the books and figures were not available; some tests of the books were frustrated; or they had some deep problem about verifying what was going on and so on, and as a result they can give no opinion on whether the accounts are true and fair.
Sometimes there is just a fundamental disagreement between the directors and auditors about what things are worth or how they should be treated. If these are such major items that they are fundamental to the state of the business, the auditors normally set out the problem – say the valuation of major long-term contracts – and state that the accounts are as a result misleading. They normally add that had the accounting treatment been as they suggested, the profits would have been so many millions lower.
Such major rows are rare because the board and the auditors argue about such items at enormous length, and auditors bend over backwards to avoid such open conflicts, if only because it is almost always the prelude to a change of auditor, so the accountants will lose a source of revenue.
Another worrying comment from the auditors is that the accounts have been prepared on a going-concern basis, which is a warning that the figures would be unjustified if the business went bust. Clearly that sort of point is not going to be made about a business with a booming present and a flourishing future.
Behind all these are the notes, frequently running to dozens of pages. It is a frightening and long set of technical-looking statistics. In fact this is where the real meat is generally buried.
A series of reports on corporate governance has produced the Combined Code, which the Stock Exchange backs, that instructs companies to include mention in their annual reports of how far they complied with the requirements. In addition, some companies provide unaudited supplements giving breakdowns by product area and country of sales, sometimes by country of manufacture and other details.
This is the section where you will find how much directors earned and what sort of incentive and share-option packages they have. It will also show how many employees there are and how that total changed during the year.
Also at the back but not usually a formal part of the notes is a table showing previous years’ performance, going back at least five and sometimes 10 years. That means one can check whether sales have risen faster than the rate of inflation and whether the trend has been a steady one or erratic. It also tends to show the step change when the boost to profit and turnover came not from organic growth but an acquisition.