No, don't run away! Company reports are easy to read -- honest!
Baffled by company reports? Scared of what surprises lurk amongst all those mind-bending numbers? Never fear; company reports are really a lot less intimidating than they might at first appear, and with a bit of practice we can learn to cast an eye over one and get a quick view of what really counts.
There's a good reason that many investment experts urge us to read company reports the wrong way round, starting at the back and working towards the front. With the occasional notable exception, a company report puts the cheery waffly stuff that is aimed at giving us a rosy warm feeling about the company at the front, with the actual meat in the form of the numbers coming later.
If we want to compare different companies, it really does help if they all have to report the same things in the same format and to the same standards. But the financial statements can also hide a multitude of sins, with all sorts of extras hidden way in what is perhaps the most important part of them all -- the Notes to the Accounts.
The Eye Candy
So, some headline figures, a few choice quotes, and the Chairman's statement -- that's what all the waffly stuff up front consists of (and, if we have the glossy printed report, there might be some nice colour photos of smiling children or gambolling spring lambs, or some such).
But there's usually little of much worth to be had there, because the purpose of those opening sections is not one of information, but of marketing -- it's all there to sell us the idea that it's a wonderful company. It might be useful for investment writers to get some quick words from when they're struggling against a publishing deadline, but investors shouldn't place too much importance on it.
Having said that, reading between the lines of the Chairman's statement can give us some clues. It is rare that it will openly give us bad news, but it can be teased out -- I think a good rule of thumb is that if it contains the word "challenging", the company has had a bad year, and if "challenging" occurs twice, it's going to have a bad one next year too.
The Financial Statements
The financial statements themselves comprise three separate sections, covering different aspects of the company.
Firstly, we'll see the company's Income Statement, which tells us how much the company has sold of whatever it is it sells, how much it cost to buy the stuff that it uses to make whatever it sells and to pay its staff to make it, and how much profit it has left at the end.
This is all split into sub-totals (before and after tax being the main split), and the bottom line tells us how much profit the company has made per share (the Earnings Per Share figure). It will also show the previous year's figures too, to give us some idea of the direction the company is going.
But, of course, profit isn't cash (not all of those sales will actually have been paid for yet, nor will all of the bought-in raw materials -- there is likely to be a complex set of credit arrangements in place). So, we also need to know how the actual cash has stacked up, and that's where the next bit comes in, the very important Cash Flow Statement.
This lists all of the cash that has flowed into and out of the company -- what it was for, where it went, etc. Comparing this to the Income Statement, we can get a good idea of how much of the stated profits actually turned into the stuff we can spend, and if they don't match up, it's time to exercise a little caution.
Another vital part of a company's operations is the stuff it actually owns, the capital it needs to run its business. It's all very well seeing a company making a nice profit, but if it needs to have squillions tied up in the business in order to make that profit, there might be better investments elsewhere in companies that don't need to tie up quite as much capital.
That brings us to the third financial statement, the Balance Sheet. This lists all of a company's assets (its plant and machinery, stocks, cash, etc), and its liabilities (from what it owes in loans to the total invested by shareholders to cover all those capital assets it uses). The balance sheet is where we get a handle on a company's debt situation, which is especially important in hard times.
The Balance Sheet will also split out short term (current) assets and liabilities, showing us how much the company owes and is owed in the short term for sales, purchases, short term loans etc, and that gives us a vital look at the company's short term liquidity.
And finally, the Financial Statements will be followed by a list of Notes to the Accounts, which can easily take up far more pages than the accounts themselves. It is here that some of the most important information is to be found. Throughout the three financial statements, we'll have seen a lot of footnote numbers, and this is where those will be explained and expanded on. There isn't room to examine the notes here, but in a future article we'll take a closer look (after having had a closer look at the three financial statements).
More Investing Basics from Alan Oscroft: