Financial journalists write extensively about companies: companies that are growing, companies that are contracting, companies that are taking over other companies, companies that are going bust. They tend to approach company affairs from one of two angles (or, most usefully, from both). Take two examples:
‘Mark Hustler, the thirty-year-old accountant who took charge at Interpersonal Video Systems earlier this year, has not let the grass grow under his feet. Following the purchase of Insight Compact Discs in June he plans a further important acquisition in the interpersonal systems field to consolidate the company’s lead in this fast-growing business. The shares are acquiring a strong institutional following and at 180p – up from 60p earlier this year – look one of the best bets in the high-technology sector’
What do we deduce from this? First, that the writer thinks Interpersonal Video Systems is a good thing, because he is advising you to buy the shares. Second, that he is suggesting the investing institutions are buying the shares, which should help the price to rise. Third, that the shares have already risen strongly, presumably since Mark Hustler took charge. Fourth, that Mark Hustler is expanding his company by buying other companies. Fifth, that the company is a leader in interpersonal systems and that these are a high-technology area. Finally, we might suspect that the writer probably hasn’t the faintest idea what an interpersonal video system is, whether it is a growth business, whether Mark Hustler is paying too much or too little for the companies he is acquiring or who the institutions are that are supposed to be following the company. In other words, the writer has clearly had a tip. It’s not necessarily to be sneezed at. If enough people follow the tip and buy the shares because they think they are going up, they will go up. For a time at least.
‘Interpersonal Video Systems, the manufacturer of visual sales aids for the toothpaste industry, reports turnover up from £18m to £27m for the year to end-March. Pre-tax profits have risen from £2m to £4.3m, including a first-time contribution of £1.5m from Insight Compact Discs, acquired for shares last June, and earnings per share are up from 10p to 12.5p on the enlarged capital. If the company meets its target of 15 per cent a year internal growth, the 25p shares at 180p are on a prospective PE ratio of only 12.5, which is below the sector average. They look undervalued.’
In fact, the message from the second writer is essentially the same as that from the first: the shares should be bought. Not because Mark Hustler is a great guy, not because another important acquisition is planned, not because institutions are rushing to buy the shares. But because the conventional investment arithmetic says that they are cheap. We also learn roughly what Interpersonal Video Systems does and we have an indication – since earnings per share have risen – that it probably didn’t pay too much for Insight Compact Discs.
Neither approach is totally satisfactory on its own. It is useful to know who runs a company. It helps us to get a feel for the operation if we know it plans expansion via takeover. It is useful to know (if, in fact, it is true) that institutions are investing in the company. But it is also useful to know what it does, how much it earns and how it is rated on accepted investment criteria.
Phrases like ‘PE ratio’ and ‘earnings per share’ are part of the currency of the investment business. But what do they mean? This requires a gentle incursion into company accounts.
First, what is a company? It is a trading entity that belongs to its shareholders and the Ltd or plc after the name indicates that it has limited liability. The plc also indicates that the company is a Public Limited Company: one whose shares or other securities may be held by the investing public and traded on a market. In either case the liability of the owners is limited to the amount of money they have put into the business. Unless they give personal guarantees for the debts of the business, the owners or shareholders (members, in the legal jargon) of a limited company cannot be called on to meet the company’s debts where these exceed its assets. Only the money put into the company can be lost. Anybody who operates a business as a sole trader or as a partner in a partnership, on the other hand, is liable for all the debts of the business.
The owners of the ordinary shares in a company normally have the power to control the company if they act together, though the directors and managers – who may or may not be shareholders – run the company. Usually each ordinary share carries one vote. Owners of more than 50 per cent of the votes will thus – if they all vote the same way – control the company. In practice, shareholders can influence the way a company is run primarily by voting on the appointment or dismissal of directors and on certain other major policy matters that have to be presented to shareholders at a formal meeting of the company. Certain major resolutions – to change the aims and objectives of a company, say – will require that 75 per cent of the votes cast are in favour.
Most of the time shareholders vote the way the directors advise them to, especially at the annual general meeting or AGM of the company, which is normally a non-contentious event where the required resolutions are duly passed. The press will generally pick up the occasions when there is dissent between different groups of shareholders or between shareholders and directors. This is where the question of voting power becomes interesting.
Ordinary shareholders are entitled to receive accounts. As a rough rule (it’s not technically quite correct) companies are required to produce a set of accounts each year. This is a legal requirement. The stock exchange further requires that listed companies produce figures showing profits at the half-year stage (in America they produce them each quarter).
The best way to look on accounts is as a sort of shorthand for what is really going on in a company. The bare figures don’t conjure up the smoking chimneys or the salesmen out on the road. But once you are reasonably familiar with the basic figurework you can begin to look at what lies behind it.
The main items in the accounts are a profit and loss account, a cash flow statement and a balance sheet. Under current accounting rules, the company should also include a statement of total recognized gains and losses and a note of historical cost profits and losses – but we do not need to bother too much with these for the moment. Various other bits of information required by law, by the accounting standards of the day (or by the stock exchange in the case of a listed company) are usually contained in the directors’ report or in the detailed notes to the accounts. In practice, the report and accounts of stock exchange-traded companies normally contain a lot more information in the form of a chairman’s statement, a review of the year’s trading and statements of compliance with various codes and practices that companies are meant to observe. Lavish colour illustrations may also bulk out the document.
With the accounts will come an auditors’ report. Auditors are firms of accountants who hold a watching brief on behalf of the owners of the company (the shareholders). The directors of the company prepare and sign the accounts. It is the auditors’ job to certify that these accounts present a true and fair view of the company’s profits and financial position, or to point out any failings where they do not. The auditors are meant to be independent of the company’s management, though obviously need to work quite closely with the managers in agreeing the form of the accounts. The managers appoint them, though the shareholders approve their fees. There is normally a certain amount of give and take when opinions vary on the presentation of different items. An auditors’ report which says the accounts do not give a ‘true and fair view’ or that they do so only with important qualifications will normally be picked up by the press as a strong warning bell.
Companies that are quoted on the stock exchange need, we have seen, to provide their shareholders with more frequent information than that supplied by the legally required annual accounts. Some weeks after the end of the first half of the company’s year it will normally produce an interim profit statement (or interim) giving unaudited first-half profit figures. The statement also normally gives the size of the interim dividend (see below) and includes some comment on trading and prospects from the company.
Some time after the end of the full year a preliminary announcement (prelim) will usually be published, giving the profits for the year and often a lot of background information. This appears some weeks before the full report and accounts are posted to shareholders. Most daily press comment on the company’s figures is based on the interim and preliminary statements which have greater news value – though less depth of information – than the full accounts.
A profit and loss account shows the results of a company’s trading over the past financial period. Usually this means a year, though the year can run to whatever date the company chooses. December 31 and March 31 year-ends are popular, though it could be April 1 or November 5. The profit and loss account thus shows the effect on the company’s revenue account of all the transactions over the past year. If a company made profits of £20m in the first ten months of its year and losses of £22m in the last two months, the profit and loss account would show a loss of £2m: the final outcome. It would not by itself reveal that the company had been trading profitably for much of the period.
Profits are not necessarily the same as cash flows, and the differences can sometimes be revealing. Take just one example. A company lends £10m to another company for two years at 10 per cent a year interest but agrees that the interest will only be paid when the loan itself is repaid after two years. In its profit and loss account at the end of the first year the lending company will include in its profits the interest of £1m which has accrued (built up) by that point. It has earned this interest. On the other hand, it has not yet received any interest in cash, so the £1m will not feature in its cash flow statement for that year.
Companies go bust primarily because they run out of cash. The cash flow statements that they have been obliged to publish since the early 1990s make it far easier to see the early warning signs (see also Chapter 4).
The balance sheet is a totally different animal from the profit and loss account and cash flow statement. It gives a snapshot of a company’s financial position on one particular date: the last day of its financial year. Everything the company owned on this date and everything it owed on this date will be shown in the balance sheet, grouped under a number of different headings. The balance sheet is usually the best measure an investor has of a company’s financial health. But it needs interpreting with caution. The position it shows on the last day of the company’s year could be very different from what it would have shown if drawn up three months earlier or would show if prepared three months later. Where companies deliberately bring forward some items and delay others, so that the balance sheet gives a picture which is totally untypical of the company’s position at any other time during the year, it amounts to excessive window-dressing. Creative accounting has a similar implication. It usually means that figures have been twisted beyond the bounds of decency to present the picture the company wants.
Note the difference between a balance sheet or parent company balance sheet and a consolidated balance sheet or group balance sheet. Most companies listed on the stock exchange are not, in fact, single companies. Bloggs Engineering plc may be a group of companies consisting of Bloggs Engineering plc, Scraggs Scrap Ltd and Muppet Metalbashers Ltd. Bloggs Engineering is the parent company or head company and controls the other two by owning all or a majority of their shares. They are therefore subsidiary companies. The head company of a group is also sometimes called the holding company because it holds the shares of the subsidiaries.
A parent company balance sheet shows the detail for Bloggs Engineering alone; its ownership of the other two companies is represented merely by the book value (value for accounting purposes) of its interest in these subsidiaries, which is generally pretty unhelpful. A consolidated balance sheet, on the other hand, treats the three companies as if they were a single entity. The assets and liabilities of all three are grouped together. Thus, if Bloggs owned buildings valued at £2m, Scraggs’s buildings were worth £1m and Muppet’s worth £1.5m, the figure for buildings (or ‘properties’) in the consolidated balance sheet of Bloggs Engineering plc would be £4.5m.
Companies are normally required to present both a balance sheet and a consolidated or group balance sheet, unless there are no subsidiaries, in which case only parent company figures are given. The consolidated balance sheet is the important one and virtually all press comment will be on the consolidated figures. Companies are not required to publish a parent company profit and loss account (unless the business consists of a single company), only a consolidated one which shows the aggregate of the profits and losses of all the different companies in the group.
In looking at a company’s finances as shown by its balance sheet (and when talking of balance sheets from now on we’ll be referring to consolidated balance sheets) it is vital to distinguish the different sources of money the company uses in its operations. There are three main sources. First, money put up as permanent capital by the owners (the shareholders) of the business. This is the company’s own money, usually put up in the form of ordinary share capital when it is also known as equity capital. Then there is the part of the profit the company earns which it ploughs back into the business rather than paying out by way of dividend to shareholders. This also becomes part of the equity funds of the business, because it belongs to the shareholders and is shown as reserves. Third, there is the money the company borrows and which it will have to repay at some point. The general term for this is debt or borrowings but it can take a lot of different forms: overdrafts, term loans (both of these are bank borrowings, which are not securities) or debentures, loan stocks, and so on (which are securities of the company).
The easiest way to understand the various accounting terms that crop up in press reports is to take a sample set of accounts. The accounts – for a mythical John Smith & Co Ltd – are slightly simplified to emphasize the main items: some of the complexities that will crop up are examined later in Chapter 5. In the interests of clarity the presentation may also differ slightly from what you will see in a real set of published accounts, though you will be able to make the transition easily. In particular, we have shown the detail of ‘Current liabilities’ or ‘Creditors due within one year’ on the face of the accounts – with a real set of accounts you probably need to turn to the notes to get this detail. First, the balance sheet (see Table 3.1). Assume that John Smith is a young company which makes, say, metal paperweights.
In fact, John Smith & Co was set up only a year ago by four friends who decided there was a future in paperweights. Each put £10,000 into the business by subscribing for 10,000 £1 ordinary shares and the company borrowed the rest of the money it required. Let us take the main balance sheet items in order.
First come the assets of the business: what it owns. Assets are defined as fixed assets or current assets. Fixed assets are not necessarily fixed in a physical sense. A company operating oil tankers would show them as a fixed asset. They are ‘fixed’ because they are not something the company is buying and selling or processing in the course of its normal trade. They represent mainly the buildings and plant in which or with which the company produces its products and services. In this case John Smith’s only fixed assets are £28,000 worth of paperweight-making machinery (we must assume that it rents rather than owns its premises). Originally John Smith paid £30,000 for this machinery, but out of its profits it has set aside £2,000 to allow for a year’s depreciation or amortization of the equipment and written down the book value by this amount. This recognizes that machinery will eventually wear out and need to be replaced.
Fixed assets are divided between tangible assets (things you can touch like buildings and machines) and intangible assets. John Smith has only tangible assets. Intangible assets could be things like trade marks or patent rights which have a clear value but no physical presence other than the paper they are written on. But the most common form of intangible asset is general goodwill. We will come back to this later.
Current assets are the assets which are constantly on the move – stocks of raw materials that will be turned into products, stocks of products that will be sold to customers, money owing to the company by customers, money temporarily held in the bank that will be withdrawn as it is needed in the business. If there were a company whose business was buying and selling oil tankers, the tankers would be shown under current assets as ‘stocks’, and not under fixed assets.
John Smith has stocks of £50,000. These comprise mainly stocks of raw metal from which the paperweights will be made and stocks of finished paperweights that have not yet been sold.
The debtors item shows the money that is owing to John Smith, probably by customers who have bought paperweights they have not yet paid for. In effect, John Smith is making a temporary loan of £35,000 to its customers, on which it receives no interest. Trade credit of this kind is a fact of business life, but it poses problems, particularly for younger companies. John Smith has had to bear the costs of producing the paperweights, which soaks up its available cash, and does not get paid by customers till some time later.
John Smith & Co. Ltd.
Balance sheet as at 31 December
|
£ |
£ |
|
FIXED ASSETS |
|
|
|
Tangible assets: plant and machinery |
|
28,000 |
|
CURRENT ASSETS |
|
|
|
Stocks |
50,000 |
|
|
Debtors |
35,000 |
|
|
Cash at bank |
5,000 |
|
|
|
90,000 |
|
|
CURRENT LIABILITIES |
|
|
|
(Creditors: amounts due within one year) |
|
|
|
Trade creditors |
20,000 |
|
|
Tax payable |
6,000 |
|
|
Dividend proposed |
4,000 |
|
|
Bank overdrafts |
8,000 |
|
|
|
38,000 |
|
|
NET CURRENT ASSETS |
|
52,000 |
|
TOTAL ASSETS LESS CURRENT LIABILITIES |
|
80,000 |
|
CREDITORS (Amounts due in more than one year) |
|
|
|
Term loans |
|
30,000 |
|
NET ASSETS |
|
50,000 |
|
Represented by: |
|
|
|
SHARE CAPITAL |
|
|
|
(£1 ordinary shares) |
|
40,000 |
|
RESERVES |
|
|
|
Profit & loss account |
|
10,000 |
|
SHAREHOLDERS’ FUNDS |
|
50,000 |
|
Table 3.1 Balance Sheet
Finally, current assets include £5,000 of cash sitting in the bank until it has to be spent.
John Smith’s total assets are therefore £118,000: the £28,000 of fixed assets and £90,000 of current assets. This figure is known as the balance sheet total. It represents everything John Smith & Co owns.
Next we have to knock off everything the company owes. The short-term debts are shown as current liabilities or creditors: amounts due within one year. These are the counterpart of current assets and are therefore deducted from current assets in the balance sheet to give net current assets (or net current liabilities if current liabilities exceed current assets).
The first item under current liabilities is trade creditors of £20,000. This is the counterpart of debtors. It represents money the company owes for goods and services it has received but not yet paid for. In other words, it is much like an interest-free loan to the company: trade credit from which the company benefits.
Each year a company has to make provision from its profits for the corporation tax it must pay on these profits. But corporation tax is payable by instalments and at any time there is likely to be some tax which the company knows it will have to pay but which has not yet been handed over. This therefore appears as a liability of £6,000 under the heading tax payable.
Next comes the dividend the company plans to pay. A company usually seeks approval from its shareholders for the dividend it intends to pay, and until they have voted to approve the dividend at the annual general meeting (AGM) which takes place at least three weeks after they have received the accounts it remains a short-term liability: something that will need to be paid in the near future. A public company normally pays its dividend in two parts: an interim dividend in the course of the year and a final dividend (which is the payment on which shareholders normally vote) when the profits for the full year are known. It is therefore the cost of this final dividend that will appear as a liability.
Finally, the company owes £8,000 it has borrowed by way of overdraft. Since an overdraft is technically repayable on demand, it has to be shown as a current liability.
Deducting the current liabilities of £38,000 from the current assets of £90,000 gives a figure of £52,000 for net current assets.
Fixed assets plus net current assets give the figure described as total assets less current liabilities. From this figure of £80,000 we still have to knock off any medium- or long-term debts, which are shown under the heading of creditors (amounts due in more than one year) before arriving at a figure for net assets. In the event, John Smith has borrowed £30,000 in the form of a term loan. This is a bank loan, typically for a period of three to seven years, and normally repayable in instalments.
After knocking off everything the company owes, we find John Smith is ‘worth’ £50,000: the net asset figure. This is the value for accounting purposes of the shareholders’ interest in the company, though it probably does not tell us anything much about what the company might be worth in the stockmarket. It equates to the £40,000 the four founder-shareholders provided by subscribing for 40,000 £1 shares at par, plus the £10,000 of profits the company has earned and retained in the business rather than paying out as dividends. The two items together constitute the shareholders’ funds of £50,000.
After looking at the individual items, translate them into a picture of the company’s financial position. It has assets of £118,000 (fixed assets plus current assets). Where did the money come from to acquire these assets? It has effectively borrowed (partly as trade credit) the £38,000 shown as current liabilities. It has a longer-term borrowing of £30,000: the term loan. Knock these two items off the assets figure and you are left with £50,000. Where did the money come from for this remaining £50,000 of assets? The answer: £40,000 was put up as share capital by the original shareholders and £10,000 was ‘saved’ out of the profits of the year’s operations.
The relationship between borrowed money (debt) and shareholders’ money (equity) in a business is important. Borrowed money has to be repaid at some point, though it might be a long way off. More important in the short run, interest has to be paid on borrowed money, and it has to be paid whether the company is earning good profits or not. A company that existed largely on borrowed money could be in bad trouble if it ran into losses for a year or so. If it was unable to pay the interest, the lenders could ask for their money back, which would usually result in the business folding up.
Equity finance does not carry this danger for the company. In the good times the shareholders reap the rewards of the company’s success, usually in the form of rising dividends. But if the company should run into trouble and make losses, it does not have to pay any dividend at all on the ordinary shares. Equity capital is also called risk capital for this reason: the shareholder is at risk.
The relationship between borrowed money and equity money in a business is referred to as gearing (or leverage in the United States). It is a term that crops up in other contexts as well. A high-geared company is one which has a large amount of borrowed money in relation to its equity or its shareholders’ funds. A low-geared company has a large equity and few borrowings. The appropriate mix of borrowings and equity depends on the type of business (see Chapter 4). If a journalist points out that a company is high-geared, he is probably suggesting that this is a good thing for shareholders if the company is doing well. If the company is doing badly, he is probably sounding a warning.
Next, look at the record of the company’s profits for the past year, as shown in the profit and loss (P&L) account: see Table 3.2.
John Smith & Co Ltd
Profit and loss account for the year ended 31 December
|
£ |
TURNOVER |
200,000 |
OPERATING PROFIT |
24,000 |
Less |
|
INTEREST PAYABLE |
4,000 |
Leaving |
|
PROFIT ON ORDINARY ACTIVITIES BEFORE TAX |
20,000 |
Less |
|
CORPORATION TAX |
6,000 |
Leaving |
|
PROFIT AFTER TAX ATTRIBUTABLE TO SHAREHOLDERS |
14,000 |
Less |
|
DIVIDENDS |
4,000 |
Leaving |
|
RETAINED PROFIT |
10,000 |
Earnings per ordinary share: |
35p |
Dividends per ordinary share |
10p |
Table 3.2 Profit and loss account
Most of these terms are pretty much self-explanatory. They don’t all have a precise legal or accountancy significance and some can be used in slightly different ways. The turnover of £200,000 is the total value of all goods and services sold by the company to third parties in the normal course of trade – it is sometimes called sales, instead. It does not usually include any taxes (like VAT) charged on these goods or services.
The difference between turnover and the operating profit of £24,000 is the costs incurred by the company in its operations during the year: wages, rent, raw materials, distribution costs, and so on. These will be broken down to a greater or lesser extent in the notes to the accounts (which contain a lot of important information and are sometimes more revealing than the accounts themselves). The costs also in this case include the directors’ salaries, the auditors’ fees and the amount set aside to provide for depreciation of plant and equipment (these items will also be shown in detail in the notes to the accounts). The operating profit is what remains after these costs have been deducted.
The next deduction is the interest the company pays on its borrowings of all kinds (for convenience we’ve ignored the fact that it may also have received a little interest on its temporary bank balances). In the notes this interest should be broken down between interest on short-term borrowings and interest on long-term borrowings. An overdraft is technically a very short-term borrowing.
After deducting the interest paid we are left with a figure of £20,000 for profit on ordinary activities before tax. Mercifully this can be abbreviated to pre-tax profit and is the most frequently quoted measure of a company’s profit, in the press and elsewhere.
Next, the tax man has his cut. Companies pay corporation tax on their profits, after all other costs except dividends have been deducted. Tax rates change relatively frequently and examples can be soon outdated. For consistency we have taken a 30 per cent corporation tax rate throughout this book (except where specifically noted) because this is the rate applying from the 2000–01 financial year. But the exact rate that companies pay on their profits will depend on a number of factors, including the proportion of profits earned overseas and various allowances that may be available. We have also ignored the fact that there is a lower rate of corporation tax that applies in practice to small companies like John Smith.
The company tax system used to incorporate a complexity that was often puzzling to the layman. It concerned Advance Corporation Tax or ACT. Though this has been abolished from 1999 (at considerable cost, incidentally, to companies and their shareholders) you will still read references to the old imputation tax system that incorporated ACT and a brief explanation is therefore needed. Under this system, the corporation tax paid by the company covered the basic rate income-tax liability on the dividends that shareholders received. So a basic rate taxpayer did not have to pay additional tax on his dividends – the corporation tax paid by the company was deemed to cover it. Shareholders who were not liable for tax at all – in particular the pension funds – could use the tax credit voucher they received with their dividends to claim back the tax that was deemed to have been paid by the company on their behalf. When the tax credit was equivalent to 20 per cent of the gross dividend payment, this meant that an 80p dividend received by a pension fund was actually worth 100p once it had claimed the tax back.
Now that ACT has been abolished, non-taxpayers no longer have a tax credit they can reclaim. The value of an 80p dividend to a pension fund thus reduces from 100p to 80p – a severe cut in its income. But while nobody (except charities, for which there are temporary transitional arrangements) can now claim back tax on dividends, a residue of the old system remains. The rate of income tax on dividends for standard rate taxpayers is now 10 per cent and for higher rate taxpayers is 32.5 per cent. The corporation tax paid by the company is deemed to cover this standard rate 10 per cent liability. A standard-rate taxpayer therefore does not have to pay tax on the dividends he receives and a higher rate taxpayer can offset this 10 per cent against the total tax due on his dividends.
The profit after tax attributable to shareholders or net profit is much what it says. Provided there are no further deductions, it belongs to the shareholders or owners of the company and may be referred to as equity earnings. But it is up to the company to decide, probably with the approval of its shareholders, how much of this profit is to be paid out as dividends and how much should be kept in the business to help finance its expansion. Most companies in their early stages need all the money they can get and tend to keep most of the profit in the business. In the case of John Smith & Co the company has decided to pay out under a third of its profits – £4,000 – as dividends and to ‘plough back’ the remaining £10,000 which is therefore described as retained earnings or retentions. The amount of cash a company has available and the amount it needs to retain for the business will affect the dividend decision, which does not depend solely on the level of profits earned. Note that occasionally companies pay cash to shareholders in forms other than a dividend: this is covered in Chapter 9. Sometimes, too, shareholders are given the chance of taking their dividend in shares rather than cash (a scrip dividend – see Chapter 9). See also foreign income dividend in the glossary. But there are no such complexities with John Smith & Co.
Remember, the £10,000 of retained earnings belongs to the shareholders just as much as the £4,000 they actually receive as dividends, which is why it was shown in the balance sheet as part of shareholders’ funds, under the heading of revenue reserves or profit and loss account reserve.
The £4,000 paid as dividends is divided equally among the 40,000 £1 shares in issue. Normally, the dividend is expressed as an amount (in pence) per share. In this case the dividends are equal to 10p per ordinary share.
The figures shown for John Smith & Co are obviously simplified. They illustrate the main figures on which the investment ratios explained later are based. But a few technicalities must be mentioned briefly.
If John Smith has interests in associated companies or related companies (companies which are not subsidiaries, but where it has a significant shareholding – see Chapter 5) it will show as a separate item its proportionate share of the profits of these companies and include them in the pre-tax profit figure.
The profit after tax will not always be the same thing as the profit attributable to ordinary shareholders or equity earnings. First, the company may have to make a deduction for minority interests or outside shareholders’ interests. These arise where a parent company controls subsidiary companies but does not own all the shares of all of them. Suppose John Smith had a subsidiary called Super Stampings. Smith holds 70 per cent of the Stampings shares, and the original founders of Stampings have held on to the other 30 per cent. So 30 per cent of the profits of Stampings belongs to these minority shareholders. Smith includes the whole of the Stampings profits in its own operating profit figure, but makes a deduction after tax for the amount of the net profit of Stampings belonging to the minority holders.
Second, the company may have preference shares in issue (see Chapter 5). In this case the dividends on the preference shares must be deducted from the net profits. Both minority interests and preference dividends must be allowed for before arriving at the net profits or earnings that belong to Smith’s ordinary shareholders.
Third, the aim of any investment commentator is to assess a company’s earning power, present and future. This means he may need to adjust the published profit figures to exclude ‘one-off’ items that distort the profits in a particular year. Again, a little history helps to explain the position. In the past, these items usually appeared under the heading either of exceptional items or of extraordinary items. They could include items such as costs incurred in closing down a subsidiary business or windfall profits on the sale of a surplus factory. Neither item would have been a normal feature of the company’s trading.
Exceptional items were added or subtracted in the published accounts above the line: before reaching a pre-tax profit figure. Extraordinary items, however, did not affect the published pre-tax profits or published earnings but were deducted below the line after striking a net profits after tax figure. What was ‘exceptional’ and what was ‘extraordinary’ was a matter for some debate. What often happened in practice was that companies treated favourable items such as windfall profits as ‘exceptional’ and therefore included them in published pre-tax profits. Unpleasant one-off items such as factory closure costs were more likely to be treated as ‘extraordinary’ and deducted after tax where they would not be so easily spotted.
But this form of window-dressing did not escape the accounting authorities and a new accounting standard, FRS 3, came into force which obliged companies to treat virtually all one-off items as ‘exceptional’ and add or subtract them before arriving at pre-tax profits and earnings per share. While this remedied the earlier abuses, it also resulted in earnings that were sometimes a lot more volatile and did not necessarily reflect a company’s on-going earnings power. So, alongside the volatile FRS 3 earnings, investment analysts normally calculate an earnings figure for the company’s on-going operations, which excludes the one-off items. Many companies themselves publish an on-going earnings figure – sometimes referred to as headline earnings – as well as the obligatory FRS 3 earnings.
The FRS 3 accounting standard also obliged companies to show the division of their profits between continuing operations, profits from new businesses acquired during the year and profits from businesses that were subsequently closed or sold. But the new millennium is likely to see still further changes in the way companies are required to present their performance. Discussions are under way about a new form of performance statement which would show not only profit as defined in the current form of profit and loss account but also changes in the value of the business resulting from revaluation of assets and similar developments.
The accounts we have looked at are prepared according to the historical cost convention. This is the traditional way accounts are prepared and is the form required for most taxation and legal purposes. It means that most items – particularly fixed assets and stocks – are normally shown at what they originally cost, less provisions for depreciation or other necessary write-offs. The main exception is that properties are sometimes revalued, with the new values included in the balance sheet.
In a period of high inflation, historical cost accounting may be misleading. Plant and equipment will cost more to replace than was paid for it originally. Stocks of raw materials will cost more when they have to be replaced.
To overcome this problem, various forms of inflation accounting, including replacement cost accounting, have been developed to supplement or replace historical cost accounts. Before reaching a profit figure, deductions will be made for the higher costs of replacing fixed assets and stocks (there are other adjustments, but these are usually the most important). The result for most companies is that profits will be lower than those shown under the historical cost convention. You still occasionally see references in the press to inflation accounting. But with the lower rates of inflation that prevailed in the 1990s, some of the steam has gone out of the debate on the merits of different accounting systems. The accounting authorities have, however, been examining the possibility of requiring companies to show more items in their accounts at present values and fewer at historical cost.
There are any number of websites that impinge on companies and their affairs. First, most major listed companies have their own websites which are often informative and provide the latest figures. You may access them easily via the Peter Temple linksite at www.cix.co.uk/~ptemple/. Details of listed companies from an investor’s viewpoint are available at the Hemmington Scott website at www.hemscott.net/. The Companies Registry has a website at www.companieshouse.gov.uk/ where certain basic information on all limited companies is provided free and you can find out how to obtain the more detailed information. And information on the accounting standards to which companies must conform are on the Accounting Standards Board’s website at www.asb.org.uk/. The ProShare organization at www.proshare.org.uk/ offers a very basic guide to published accounts.