THE AIM OF THIS BOOK is to provide an understanding of how to analyse and assess the performance and financial position of a company from the various sources of information available. Financial analysis is as much an art as it is a science. Combine any two figures from an annual report and a ratio is produced; the real skill is in deciding which figures to use, where to find them and how to judge the result.
Before attempting to analyse a company, a sound grasp of financial terminology and presentation is required. Part 1 of this book explains the content and intent of the main financial statements appearing in a company’s annual report: the statement of financial position (balance sheet); the income statement (profit and loss account); and the statement of cash flows. Two newcomers, the statement of comprehensive income and the statement of changes in equity, are also covered.
All countries and companies share the basic accounting framework used in the preparation of financial statements, but their presentation is not yet completely standardised. Adjustments may have to be made, but the outline in Part 1 is applicable to most companies and countries. Reference is made to UK and US GAAP (generally accepted accounting principles) as well as the appropriate International Accounting Standards or International Financial Reporting Standards (IAS or IFRS), but there is no attempt at a detailed interpretation of their application. This is an area of study you may move on to after this book.
As far as possible, the examples given have been kept simple in order to emphasise or reinforce the subject matter; once the fundamental theory and practice are grasped there should be no problem in moving to more detailed and sophisticated analysis. In general, the book’s examples focus on retail, service and manufacturing companies rather than banks and other financial services companies, which are subject to a different set of legal and reporting requirements.
Part 2 deals with the analysis of the different aspects of corporate performance and position. Three important ground rules apply:
Profit and finance are the two broad strands interwoven in the overall management of successful business organisations today. They also provide the basis for the analysis of a company. Each strand is equally important and both must be followed. Analysing a company’s profitability without any reference to its financial position is of little value. Similarly, there is little point in completing a detailed analysis of a company’s financial structure without reference to its performance. Profit is not sufficient on its own; a company must have the resources to allow it to continue in business and to flourish.
A common corporate objective is to achieve a level of profit necessary to satisfy shareholders’ requirements – to add value to their investment. Without profit there can be no dividend or share value improvements, or reinvestment for future growth and development. A substantial part of this book focuses on various ways of identifying and measuring profitability. Shareholder value is more than just annual profit, and not everything is capable of quantification. Future expectations of a company’s performance outweigh its historical track record in determining its share price – which probably offers as good an indicator as any of shareholder satisfaction. Chapter 5 offers some general guidelines for undertaking practical analysis.
When the analysis of a company is completed, the tables in Appendix 1 offer some benchmarks against which the ratios explained in Part 2 can be tested and compared. This reinforces the last lesson of financial analysis: comparison. Producing a series of ratios for one company can be useful in indicating trends in its performance, but it cannot confirm whether this is good, bad or indifferent. That can only be determined by applying the three rules stated earlier.
An important lesson from the downturn in the 1990s and the 2008 global financial crisis is to invest in a company only when you are absolutely certain you understand the business and sector within which it operates. If you cannot see where the profits are coming from, don’t invest. If you cannot understand what the company does, don’t invest. In all probability it is not a failure of your analytic ability but someone practising corporate legerdemain.
The question of whether to use rules or principles as the basis guidance in the preparation and presentation of financial statements appears to have been answered. Financial reporting now operates under a set of mainly principles-based accounting standards kept on the straight and narrow by additional guidance and professional auditors as necessary. The main objective of the International Accounting Standards Board (IASB) is “to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards”, and it is working with the Financial Accounting Standards Board (FASB) towards this.
Despite recent changes, the terminology of accounting and financial reporting remains much the same, though the importance attached to some has changed. Understanding the meaning of the terms “recognition”, “fair value”, “present value”, “faithful representation” and others is essential to reading a set of accounts. This book is not intended to provide a detailed toolkit for financial report preparation but, rather, to give you confidence in using the information contained in an annual report. Throughout the book the FASB or IASB statements and terminologies are selected as being the most appropriate to clarify the item or topic being discussed. This is not a textbook. The aim is to provide you with some confidence in reading the accounts, and moving to the next level in your financial analysis and management competence.
As far as possible the book is written with a light touch. It is not intended to be read from start to finish – dip in as appropriate. If you find a section hard going – move on; it will be my fault not yours.
Companies get their momentum from people, and financial analysis of their activities is an art. Art combined with people should be fun: if it is not, you should leave it to those who enjoy it.
Bob Vause
August 2014