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Company accounts analysis
How to interpret
financial statements |
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All UK listed companies
have been required to use International Financial Reporting Standards since 1
January 2005. These are harmonized accounting standards intended to bring about
global comparability. Unlisted companies, including on the Alternative Investment
Market, may continue instead to follow UK Generally Accepted Accounting Principles
(GAAP).
For all UK company
accounting, there is an interim statement after the first six months. Shortly
after the full year, the company publishes full year figures, known as preliminaries,
and then the full audited annual report and accounts. The most important financial
statements are the balance sheet, the profit & loss account, also known
as income statement, and the cash flow statement. We will look at each in
turn.
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The balance
sheet
The balance sheet
is one of the three main financial statements in the company report and accounts.
It is a snapshot of the company’s position at a given point in time.
The assets and liabilities shown are a combination of those shown at historical
cost and those requiring fair valuing each period. Let us take a look at the
items included.
On the top half
of the balance sheet are the company's assets, those items the company
owns.
These are offset against the company’s liabilities, which are
what it owes.
Total assets less total liabilities equal the net assets of the company.
Current assets less current liabilities make net current assets, which is
the amount available to pay bills within the year.
Issued share
capital and reserves make up shareholders' funds. These, together with
any
minority interests, are equal to total capital employed.
The key rule of the balance sheet is that a company's assets equal its liabilities
plus its shareholders’ funds. In this way, the balance sheet balances.
Here
is what an IFRS-style balance sheet looks like. In this mock example,
x stands for a positive amount and (x) for a negative amount.
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The profit and
loss account/income statement
The profit & loss
account, or income statement, records the company's profits or losses, and
how they
were reached, over the previous financial year.
At the top of
the profit & loss account is turnover (or revenue),
which is all of the ordinary income received by the company. Cost of sales,
including production overheads, depreciation, and stock changes (stock valuation),
is deducted with other expenses on a net basis from turnover. The profit & loss
account will state what the total operating profit figure is. In UK accounts,
the charge for tax is typically less than the pre-tax
profit multiplied by the tax rate. It includes corporation tax and deferred
taxation.
Corporation tax
is paid on the company's income and capital gains, usually nine months after
the
company's year-end. Deferred taxation acknowledges liabilities
or assets in relation to timing differences existing up to the balance sheet
date. Following UK GAAP, the company will need to provide
for deferred taxation on the profit & loss account only "to the
extent that a liability or asset will crystallise." However, under IFRS
this changes so that deferred tax is recognised on all differences between
the
accounting balance sheet and the tax base of the asset or liability.
Here
is what an IFRS-style income
statement looks like.
In this mock example, x stands for a positive amount and (x) for a negative
amount.
The cash flow statement
The cash flow statement
presents movements in cash and other assets that are similar to cash (cash equivalents).
All cash flows are split between operating, investing and financing items. This
is arguably the part of the accounts that investors find most useful
because it is easy to understand and not impacted by subjective judgements.
The statement starts with cash flow from operating activities. It may present
this in a direct way as cash received from customers, less cash paid to suppliers,
employees and others.
More usually,
it will present this in an indirect, more complicated way, reconciling profit
before tax to operating cash flow. If so, it will start with the profit
before tax, and add back depreciation, as this is not a cash flow. Any
increase in debtors is subtracted as it means less cash for the company while
the debts are outstanding. Any decrease in stocks or increase in creditors
is added back, as it means more cash.
Net cash from
operating activities on the cash flow statement will be preferably about
the same as,
or, better still, higher than, the operating profit on the
profit & loss account.
Next comes the investing cash flows section. This includes cash flows relating
to the purchase or sale of long term assets. It will also include cash payments
and receipts relating to the purchase or disposal of debt or equity in other
companies. Interest payments and receipts and dividends will also appear in
this section.
Finally we have the financing section. These cash flows relate to the way
in which the company obtains cash to finance its operations.
Here
is what an IFRS cash flow statement looks like. In this mock
example, x stands for a positive amount and (x) for a negative amount.
The chairman's statement
The chairman's statement - also included in the accounts - can contain a lot of hype and you must learn to read between the lines.
The operating and financial review
The OFR provides
a balanced and comprehensive view of how the company is developing, its performance,
its position, and trends
and factors affecting its business.
The director's
report
The director's report
will help you to understand the numbers, and will have some extra non-financial
facts.
The statement of recognised gains and losses
This links the profit and loss account to the balance sheet.
The auditor's
report
The auditor's report
normally
tells
you that everything is true and fair. If it is in any way qualified,
avoid
investing in the company.
The notes to the accounts
The nasties are often
concealed in the notes. Watch out in particular under Contingent liabilities for
potential high expenses that the company may face if, for example, it loses a
forthcoming legal case. Watch too for a change in the method of depreciation,
which would affect both the life of assets and the profit and loss
account.
The next step
These are the bare
bones of a set of accounts. For more detail, read The
Times: How to Understand the
Financial Pages, by Alexander Davidson, published by Kogan Page.
This
book is IFRS-compliant.
For some basics of accounting and ratio analysis, read The Complete Guide to Online Stock Market Investing, by Alexander Davidson, published by Kogan Page.
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