This article introduces the key concepts of accounting for investors. Its intention is to better enable investors to understand and interpret the financial statements of businesses they might invest in.
Accounts provide a (hopefully) objective analysis of the state and performance of a business. Accounts of listed companies must be prepared according to both the law and Generally Accepted Accounting Principles (GAAP).
Listed companies must have their accounts audited by qualified, independent, auditors to verify the accounts conform to the law and GAAP. Look closely at the auditor’s statement. Any hint of concern here should be cause for alarm.
The four basic accounting principles are accruals, prudence, consistency, and viability.
* Accruals – Items are recorded when their income (or expenditure) arises, not when it is actually received or paid.
* Prudence – Figures must be shown in a conservative (pessimistic) way.
* Consistency – Accounting methods can vary from company to company, however, for a given company the methods used must remain consistent from year to year. If a company changes its accounting methods, this change must be reported.
* Viability – Accounts are prepared on the assumption that the company will remain in business.
Because companies can legitimately adopt different accounting methods it is not always possible to directly compare the accounts of one company with another. However, because of the consistency principle, it is possible to monitor a particular company’s performance over time from its financial statements.
Financial statements usually include letters from the chairman and board of directors. These will usually serve to tell you what a great job the management team have done, but can sometimes provide useful hints as to likely future initiatives.
The three key financial statements are the Profit and Loss Account, the Balance Sheet, and the Cash Flow Statement.
Profit and Loss Account
The Profit and Loss Account summarizes a business’s performance over a period (usually a year).
Sales (turnover) = total sales revenues.
Cost of Sales = production overheads, raw materials, employees, product development, changes in stock levels, depreciation.
Gross Profit = Sales – Cost of Sales.
Operating Costs = costs of administration, distribution, marketing.
Operating Profit = Gross Profit – Operating Costs. (Also referred to as profit before interest and tax, PBIT).
Profit Before Tax = Operating Profit – Profit (+ Loss) on Sales of Fixed Assets – Net Interest Payable.
Balance Sheet
The Balance Sheet is a snapshot of a business’s financial position (what it owes and owns) at a particular moment in time.
The Balance Sheet is based on the accounting equation:
Assets = Liabilities + Owners’ Equity
Fixed assets are assets that a business does not buy/sell as part of its business.
Tangible assets are physical things, eg buildings, machinery etc.
Intangible assets include brand names, patents, licenses, goodwill (the amount by which the price of a business exceeds its assets) etc.
Current assets are assets that can be converted to cash within a year, eg inventory (stocks of goods for sale or raw material), debtors (money not yet received for sales), investments, cash etc.
Current Liabilities are debts due in the next 12 months, eg creditors (money owed to suppliers), accrued expenses (phone, rent… incurred but not yet paid), outstanding dividends, tax due within next year.
Long Term Liabilities money owed but not due within next year, eg bank loans.
Net Current Assets (working capital) = Current Assets – Current Liabilities.
Total Assets less Current Liabilities = Fixed Assets + Current Assets – Current Liabilities.
Net Assets = Total Assets – Total Liabilities.
Shareholder’s funds (owners’ equity) must equal net assets.
Share Capital is the money put into the business by shareholders.
Retained Profit is the cumulative retained profit from the Profit and Loss Account since the business started.
Revaluation Reserve results from a business revaluing assets (eg buildings) at current rather than original costs.
Cash Flow
The last (but certainly not least important) financial statement is the cash flow statement. This statement shows the movements of cash into or out of the business. No matter how healthy the profit & loss account and balance sheet may appear, without sufficient cash a business will fail.
The Operating Profit (from the Profit and Loss Account) is adjusted for non-cash items.
* Depreciation is added back in.
* Any increase (decrease) in inventory is subtracted (added).
* Any increase (decrease) in debtors is subtracted (added).
* Any increase (decrease) in creditors is added (subtracted).
These adjustments give the Operating Cash Flow.
From the Operating Cash Flow the following are subtracted to give Cash Flow before Financing:
* Interest paid.
* Dividends.
* Taxation (actually paid in year).
* Capital expenditure (eg on fixed assets).
* Any other exceptional costs (eg settling a legal action).
* Financing shows cash generated from or lost to external financing, eg changes in loans, issues of share capital etc.
Movement in Cash is the sum of Cash Flow before Financing and Total Financing, and must agree with the change in cash figures on the current and previous year’s balance sheets.