www.InvestmentGuide.co.uk
www.InvestmentGuide.co.ukShares A Beginners Guide to Making Money Contents
Companies spend a great deal of money producing glossy annual reports but few shareholders do more than glance at the pictures and skip through the Chairman's review. Admittedly, the columns of figures look bewildering and the serious investor will need to make a proper study of the subject but you don't need to be a chartered accountant to gain some useful information from the report and accounts.
The report and accounts are supposed to give a true and fair view of the state of affairs of the company and should the auditors think that this condition has not been met they must say so. Read the auditors' report and if it contains any criticism, consider ditching the shares.
The main problem with company accounts is that they are always significantly out of date. They tell you what has happened but not what is happening now. Always be wary that the future will turn out to be the same as the past.
Profits
Turning to the accounts, a lot depends on how the net profit figure is calculated. How much has been deducted in the way of depreciation, an allowance for the cost of capital assets which will eventually need to be replaced, and other provisions? If this figure is insufficient it could mean that the company appears more profitable than it really is. An explanation can be found in the notes on the accounts which are generally more revealing than the accounts themselves because they give the story behind the bare figures.
Do the current assets, money the company has or is owed, exceed the current liabilities, money it owes? If not, the company may have difficulty in meeting its immediate bills and that could mean that it has to sell a fixed asset such as a machine or a building in order to pay a current liability. This is not a good sign. Again the notes are important to see how the figures are made up.
If you exclude the stock (eg items which have been manufactured but not yet sold) from the current assets and divide these assets by the current liabilities you get the quick assets ratio. This is known as the acid test because it indicates how vulnerable the business is to the immediate presentation of all its bills. The traditionally minimum acceptable ratio is 1.1 but the higher the ratio the better. Any figure below 1.0 spells danger for a manufacturing company. Retailers may often fail this test but this is no cause for worry.
Past performance
Whereas the balance sheet shows the financial state of the company on one particular day, the statistical summary shows the financial record over the past five years or more. Is the profit growing or falling? A steady growth is best. Violent swings are dangerous.
Are the profits running in roughly the same proportion as the turnover, or better still, increasing? More business without higher profits spells trouble.
The return on capital employed shows how profitably the company is being run. If the figure is falling over a period of time and is lower than other companies of the same type, you need to watch out. The ratio is calculated by taking the profit before tax and dividing it by the total of shareholders' funds (share capital plus reserves) plus loans and less any goodwill. To save you the trouble of working this out yourself, many companies quote the ratio in their financial report.
The net asset value per share represents the underlying value of the shares if the assets were sold and divided amongst the shareholders. It is the shareholders' funds less goodwill divided by the number of shares issued. If it is higher than the market value of the shares then the shares are selling at a discount. This does not necessarily mean that they are a bargain. You must consider all the other factors especially the company's prospects in the market place.
Many investors monitor these ratios over a period of time and compare them with other companies. But remember they are merely indicators and a proper assessment of a company is a much more complicated affair.
An item I find of special interest is the number of shares held by the directors. To put it crudely I am encouraged when I see that they are prepared to put their own money where their mouth is. Their holdings and recent changes in such holdings are clearly detailed in the annual report.
The Financial Times, other newspapers and the Investors Chronicle closely analyse annual reports soon after they are published. A study of such analyses with the actual report alongside will soon put you in the position to understand them yourself. Start off with companies in the high street, that is those you can relate to, and you will be surprised at the amount of detail you can absorb.
Last updated 2
January 2009.