Introduction
When you open an annual financial report today, one of the first things you ask yourself is, ‘Can I believe the numbers that I’m seeing?’ At one time no one doubted the numbers. Everyone believed that any corporate financial report, audited by a certified public accountant, was truly prepared with the public’s interests in mind.
However, the financial scandals of the late 1990s and early 2000s destroyed public confidence in those numbers, including millions of investors who lost billions in the stock market crash that followed after many of those scandals came to light. Sure, a stock market bubble (a period of rising stock prices that stems from a buying frenzy) had burst, but financial reports that hid companies’ financial problems fuelled the bubble and helped companies put on a bright, smiling face for the public. After these financial reporting scandals came to light, more than 400 public companies in the US alone had to restate their earnings.
Many people still wonder what government regulators and public accountants were thinking and doing during this entire fiasco. How did the system break down so dramatically and so quickly? Although a few voices raised the red flags, their pleas were drowned out by the euphoria of a building stock market bubble.
These financial scandals occurred partly because the City measures success based on a company’s periodic results. Many in the City are more concerned about whether or not a company meets its short-term expectations than they are about a company’s long-term prospects for future growth. Companies that fail to meet their expectations find their shares quickly beaten down on the market. To avoid the fall, companies ‘massage’ their numbers. And this short-sighted race to meet the numbers each period is a big reason why these scandals occurred in the first place.
Since the scandals broke, legislators and regulatory bodies have enacted new laws and regulations to attempt to correct the problems. In this book, we discuss these new regulations and show you how to read financial reports with an ounce of scepticism. We also give you a bunch of tools that can help you determine whether or not the numbers make sense. We help you see how companies can play games with their numbers and show you how to analyse the figures in a financial report so that you can determine the financial health of a company.
About This Book
In this book, you find detailed information about how to read the key financial statements – the balance sheet, the income statement, and the statement of cash flows – in a financial report as well as discover the other key parts of the report that you should scour. (Turn to Chapters 6, 7, and 8 to find out more about these important statements.)
Many people skim or skip over three crucial parts of annual reports – the auditor’s report, the notes to the financial statements, and management’s discussion and analysis. (See Chapters 5 and 9 for more info on these parts.) In fact, in these parts, you find most of the juiciest information. Unlike the fancy, glossy coloured pages that lead off the report and give only the information that a company wants you to know, these less graphically appealing black-and-white pages give the key data that you need to know.
Although we can’t promise that you’ll be able to detect every type of company problem or fraud, we can promise that your antennae will be up and you’ll be more aware of how to spot possible problems. When you finish reading this book, you’ll understand what makes up the parts of a financial statement and how to read between the lines, using the fine print to increase your understanding of a company’s financial position. You’ll find out about who regulates the companies and certifies the truth and fairness of financial reports and how the rules have changed since the corporate scandals broke.
Conventions Used in This Book
Our principle concern here is with public limited companies that you may choose to invest in. But we also include some information on different types of company, small as well as large. (To find out more about company types and structure, see Chapter 2.)
To help you practise the tools we show you in this book, we use the annual reports of two large retailers, Tesco and Marks and Spencer, and dissect their annual reports in various chapters throughout the book. We also include their financial statements in Appendix A so that you can practise with the actual reports. You can download a full copy of the reports by visiting the investor-relations section of the companies’ Web sites: www.tesco.com and www.marksandspencer.com.
What You’re Not to Read
Many of the topics discussed in this book are, by nature, technical. Dealing with finances can hardly be otherwise. But in some cases, we provide details that offer more than the basic stuff you need to know to understand the big picture. Because these explanations may not be up your alley, we mark them with a Technical Stuff icon (see the section ‘Icons Used in This Book’ later in this chapter) and invite you to skip them without even the slightest regret.
If you want, you can also skip over the sidebars (the grey shaded boxes) as these cover only example material or anecdotes. They’re interesting to read through, but you won’t miss the meat and veg by skipping them.
Even if you skip these items, you still get all the information you need. On the other hand, if you savour every financial detail or fancy yourself the bravest of all financial report readers, then dig in!
Foolish Assumptions
To write this book, we made some basic assumptions about who you are. We assume that you:
Want to know more about the information in financial reports and how you can use it.
Want to know the basics of financial reporting.
Need to gather some analytical tools to more effectively use financial reports for your own investing or career goals.
Need a better understanding of the financial reports that you receive from the company you work for to analyse the results of your department or division.
Want to get a better handle on what goes into financial reports, how they’re developed, and how to use the information to measure the financial success of your own company.
Both investors and company insiders who aren’t familiar with the ins and outs of financial reports can benefit from the information and tools included in this book.
How This Book Is Organised
This book is organised into seven parts. After introducing the basics, we carefully dissect what goes into financial reports, giving you the tools you need to analyse those reports. We introduce you to the company outsiders who are involved in the financial reporting process and show you how to find red flags that might indicate deceptive or fraudulent reporting.
Part I: Getting Down to Financial Reporting Basics
Part I discusses the basics of accounting and financial reporting. If you need an introduction to these basics, or just a simple refresher course, you may want to begin here. In this part, you find information about the types of business structures, the differences between public and private companies, and the accounting basics necessary to understand financial reports.
Part II: Understanding Published Information: Annual Reports
This part introduces you to the key elements of an annual financial report. The first chapter in this part reviews the key sections of an annual report; the chapters that follow focus on each of these parts individually, explaining what you’ll find in a financial report and how to use that information. Another chapter explains in more detail what you can expect to find in the notes to the financial statements and what all that small print means. In the last chapter of this part, we discuss consolidated statements and the information that goes into them.
Part III: Analysing the Numbers
In this part, we give you the tools you need to analyse the numbers in financial statements. We show you how to test profitability, liquidity, and cash flow. These tools help you determine whether or not the company is a good investment.
Part IV: Understanding How Companies Optimise Operations
This part focuses on using financial statements to measure how efficiently management is using its resources. We review the basics of budgeting and how to use financial reports in the budgeting process. You also find tools for testing how efficiently companies manage their assets and keep cash flowing.
Part V: The Many Ways Companies Answer to Stakeholders
In this part, we focus on the outsiders involved in the financial reporting process. We review the role of auditors and the accounting rules and look at the role analysts play in the world of financial reporting. We also talk about shareholders and what they should expect from the companies that they invest in. In addition, we discuss how some companies ‘massage’ the numbers when they compile their financial reports.
Part VI: The Part of Tens
In the Part of Tens, we give you quick-reference lists pointing out the top-ten online resources you can use to do your financial research about companies and the top-ten signs that indicate that a company is in financial trouble. We also outline some of the juicier financial reporting scandals of the past several years.
Part VII: Appendixes
Appendix A includes two actual financial reports from the retailers Tesco and Marks and Spencer. We refer to these reports throughout the text. Appendix A also contains the results of the analysis carried out in the chapters. And, because much of the language of financial reporting may be new to you, we include a glossary in Appendix B.
Icons Used in This Book
Throughout the book, we use icons to flag parts of the text that you’ll want to notice. Here’s a list of the icons and what they mean.
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Where to Go from Here
You can start reading anywhere in this book, but if you’re totally new to financial reports, start with Part I so you can get a good handle on the basics before delving into the financial information. If you already know the basics, turn to Part II to start dissecting the parts of a financial report. If you’re ready to get started on the road to analysing the numbers, turn to Part III. If your priority is tools for optimising company operation, you might want to start in Part IV. Those of you who want to know more about company outsiders involved in the financial reporting process may want to start at Part V.