How to Read Company Accounts.
When you get a set of accounts in front of you for the first time it may seem a little daunting, but when you understand a few basic principles and definitions, a set of accounts should be a little easier to fathom out and a real insight into a company or a partnership.
It may be your own business accounts that you are looking at, it may be the financial statement of a company you are considering investing in, or it may be the accounts of a partnership you are about to join, either way learning how to read and understand the set of accounts in front of you is essential, and this short guide takes you through the process of doing just that.
Where to Start.
The first thing you may see in a set of accounts is the chairman’s statement, this usually explains the accounts and the strategic direction that the company is moving, this may well be absent in some smaller companies and partnerships.
Its always worth looking to see if the accounts are ‘end of year’ or ‘interim’ accounts, interim accounts may be more up to date yet may not be complete, it also makes sense to look at a number of end of year accounts for previous years in addition to interim accounts up to present day if this is at all possible.
Lets take a Closer Look.
In a typical set of accounts on one of the initial pages there will be two columns of figures one of which is the most recent figures, and the other column usually that of last years figures.
Consecutive years of accounts must be compared as it is essential to see which direction a business is going in addition to any liabilities and debts that may have been carried forward, if only a single years accounts are displayed I suggest you ask to see the previous years accounts so that any comparisons and trends can be seen, the last thing you want to do is invest time and effort into an organisation going down hill or that has hidden liabilities.
Typically the next few pages in the accounts contain have either the Profit and Loss Statement for a trading organisation (that means a business that sells something), or an Income and Expenditure Statement for non-trading organisations such as a Partnership.
Profit and Loss Statement.
The Profit and Loss statement is the profits and losses of the business over a period of time which is usually over the financial year.
On this page of the accounts the first figure you will see is the total turnover, next the total costs are deducted to get the gross profit, then commonly administration and other expenses are then deducted to give what is known as the EBITDA (which is an acronym for earnings before interest, tax, depreciation and amortisation).
The important issue with the EBITDA is that this figure represents the earnings before tax is deducted, the EBITDA is also an indication how much money a company has to service its debts, essentially the EBITDA equates to profitability, but not cash flow especially the cash required to fund working capital and the replacement of old equipment, which can be significant.
The next line on the accounts is usually where amortisation and depreciation is factored in which leaves the operating profit (or EBIT) which is how much a company has made over the period of the profit and loss statement.
Once interest is deducted, we are left with the earnings before tax, also referred to as the Pre-tax Profits this is the figure that the Tax man is interested in, a good rule of thumb is that pre-tax profits should be steadily increasing compared to the previous years accounts.
When tax is deducted from the Pre-tax profits we are left with the Profits after Tax, which is also referred to as the Net Income.
Occasionally profits after tax is sometimes used to give a ratio called the EPS, which is simply the earnings per share or the specifically the profits after tax/number of shares.
Income and expenditure Statement.
Typically the Income and Expenditure statement replaces that of a Profit and Loss statement in the accounts for a non-trading business an example of this in the UK would be the accounts of an NHS medical partnership.
Typically Income coming into the business is listed and summarised from its various sources to give the Gross income.
Reimbursed expenses are then added here to the Gross income to give the total income.
Total Income = Gross Income + Reimbursed expenses.
Expenditure is then summarised below income, expenditure is the cost of running the business and it includes the cost of staffing, premises, administration, finance, depreciation, and anything else.
The income and expenditure is then combined to give us the Net Income of the business.
Net Income = Total Income – Expenditure.
Typically at this stage in a set of partnership accounts the next page looks at distribution of the net income allocated by profit share of the partners.
The Balance Sheet.
The Balance Sheet is the part of the accounts that gives us a financial snapshot of a business at any given time, it is an indication of how healthy the company or partnership is at the time the accounts are generated, typically this snap shot is taken on the last day of the financial year, The balance sheet deals with 2 things the Assets and the Liabilities.
An Asset is something that is owned by your company or that you get a benefit from.
A Liability is an obligation, probably a debt arising from a past event.
Assets can be ‘fixed’ (something around for a long period of time), fixed assets can be ‘tangible’ i.e. something real like property, machinery, or computer equipment, or assets can be ‘intangible’ like goodwill, intellectual property or investments in other companies.
Assets can also be ‘current’ which refers to stock, money in the bank account, petty cash and debtors, current assets are short-term assets that are used in the day-to-day running of the company.
In business cash flow is one of the most important factor that decides if the company is solvent and it can continue trading this is directly related to the money in the bank particularly ‘the current assets’.
If we look more closely at the numbers we can look at the current assets and take away the stock which is difficult to turn into cash (i.e that which is not a liquid asset), then we can divide this by the liabilities, this is called the Acid Test Ratio, it should be greater than 1 if the company’s accounts are healthy.
Acid Test Ratio = (Current Assets – Stock) / Liabilities
Another thing we can calculate from the balance sheet is ‘what the company is worth’, this is referred to as the Net Asset Value (NAV), which is the total assets (fixed and current assets) minus the total liabilities (long-term and current liabilities).
Net Asset Value = (Fixed and Current assets) – (Total liabilities)
This may be expressed as Net Asset Value per share which is the simply the Net Asset Value divided by the Number of Shares issued.
If the company is listed on the stock market we can also look at the current price the company is trading at and compare this to the net asset value per share to help is decide if the company is worth investing in (i.e. are the listed shares under or over priced).
Accounts should be drawn up on as ‘Accrual’ basis.
This refers to the accounting principle that accounts are prepared when transactions are made not when money is paid. This is what you have done and what you have earned and NOT the cash that has come through.
The Cash flow Statement.
The Cash flow statement in the accounts is essentially the raw cash generated by the business and also the cash equivalent flowing out of the business.
The Cash flow statement is different to the Profit and Loss or the Income and Expenditure statements as is not made up on an accrual basis, it is the actual movement of money into and through a business over a given time, the cash flow statement reflects how much money is coming into a business and also when it comes in.
The Cash flow statement breaks up cash flow into three things;
Operating activities, (converts the accrual income into cash).
Investing activities, (purchase and sale of investments).
Financing activities, (if company has issued or purchased its own stock).
There may well be supplemental information stated after this in the statement, this looks at any other exchange of items that do not involve cash, and also the income tax paid.
Using the Profit and Loss and Cash Flow information one thing we can do is that we can attempt to reconcile the company’s income to its cash flow or in other terms how effectively income is turned into cash.
The take home message about the Cash Flow statement in a set of accounts is that if a company is generating a lot of cash this is generally seen as a healthy thing.
Learning to read a set of accounts is a must for any entrepreneur, businessman or investor, after reading the information here get a set of accounts and go though them, like many things in life becoming familiar with accounts gets easier with practice.