A whole new generation of shareholders is facing the challenge of protecting its investments by monitoring company performances and learning to read the signals which affect them.
The shareholders are emerging from the demutualisation of building societies and life assurance companies and the privatisation of State-owned companies - newcomers to the stock market and to the factors which influence the companies listed on it.
An important starting point in understanding the company, what it does and how it has performed is its annual report. Every shareholder receives an annual report from the company in which he or she holds shares. This report, from the board of directors, sets out the financial performance of the company for the year just ended and the financial position of the company at the end of that year. It includes a statement from the chairman about how the company has performed since the end of its financial year.
Company accounts are necessarily a historical record by the time the annual report appears - companies produce accounts for 12-month periods ending on the last day of their financial year and by the time the accounts are prepared, audited and published it will be at least three months after the financial year ended.
For this reason shareholders should read very carefully the statement from the company chairman for an indication of how the company is performing in the current year. In it the chairman should tell shareholders the factors influencing company performance since the end of the financial year.
Warning signals in a statement would be any indication not previously known that the results for the current year could be below expectations. This could include disclosures of slow or difficult trading in a particular export market, or production problems.
Generally, big investors - mainly pension and other fund managers - do not like surprises. Broadly this means they do not want to see a company's performance fall below market analysts forecasts. Unpleasant surprises usually result in a sharp drop in a company's share price as the fund managers bail out. And because it is difficult for small investors to sell quickly they are likely to suffer most when share prices fall. Usually these surprises come in the form of a profit warnings from a company sometime during a financial year.
But sometimes careful reading of the statement and the figures in an annual report could provide signals that a shareholder could follow up by watching, for example, trends reported in newspapers.
After studying the chairman's statement, shareholders should look at the financial results. The results are provided mainly in the form of a profit and loss statement, a balance sheet, a cash-flow statement and a statement of total recognised gains and losses. Bearing in mind that these are now historic results what the shareholder is looking for are trends that give some indication of how the company is likely to perform in the future. Positive indications would include a trend of steadily rising profits, earnings per share, dividends and total assets.
The profit and loss account records the financial performance for the year - broadly sales less costs equals profits. A number of profit figures will be provided. With all of these figures the most important thing to look for is a steadily rising trend year after year.
If there is any dip it is important to look at the figures for an explanation - it could be because the company spent money on restructuring and redundancies which will lead to a resumption of profit growth in future years. However, if the dip was because turnover (sales) fell or because the ongoing costs of running the operation rose faster than sales it should be cause for shareholder concern.
Changes in accounting rules in recent years have made it easier for shareholders to understand company accounts, though much remains to be done. One important change is that companies which pull out of a business or sell an operation now have to separate the results attributable to the discontinued operation from those of the continuing operations. This allows shareholders to see how the operations that remain have performed. One of the most important profit figures is operating profits - the profits a company makes on its core operations before any income from investments or deposits and before it pays any interest costs on funds borrowed to run the operation.
The profit before tax figure (PBT) will indicate how much of operating profits are required to pay for the funds borrowed to run the business - interest costs. But entries just before the PBT figure should be read carefully. At this point, the company must disclose any "exceptional" items - these would include any profits/losses on the sale of a business or property or large restructuring costs.
Since the PBT figure will include these items, shareholders may find the operating profit from continuing operations a more useful figure in assessing likely future performance. Profit after tax (PAT) shows the amount of profit the company has generated for its ordinary shareholders and this figure divided by the number of shares in issue gives the earnings per share. It is an indication of how much the company can pay out in dividends to shareholders, though some funds will be retained for future investment.
Another recent useful accounting change which has effectively got rid of "extraordinary" items makes accounts more meaningful for shareholders. Before this change companies could classify a large, unusual and once-off positive item as exceptional but if it was negative they could classify it as extraordinary.
An exceptional and positive item would boost profits before tax while an extraordinary and negative item would no longer be included within the PAT figure and therefore did not reduce earnings per share. Nowadays extraordinary items are virtually unheard of and exceptional items have to be clearly disclosed. A company's balance sheet is a snapshot of its financial position at the end of its financial year. Among the important figures are those that show how the company is funded and what it owns.
Funding usually comes from a mix of debt and equity, or funds contributed by shareholders. The level of net debt which a shareholder will have to calculate - long-term and short-term borrowings less cash held - is important. Interest has to be paid on debt and where the level of debt is rising this could become a problem. Analysts usually judge the level of debt in proportion to shareholders funds, a measure called gearing. If gearing - debt as a percentage of shareholders' funds - is getting too high analysts consider the company to be at financial risk. In trying to assess the company what the shareholder should look for are trends: is the level of net debt rising, if so, is it clear from the figures why it is rising, for example, acquisitions or purchase of fixed assets, or, does the company need to borrow more to fund ongoing operations?
Shareholders' funds are usually made up of many different amounts including funds raised through the issue of shares, retained profits (those not paid out as dividends to shareholders over the years) and reserves such as could arise from the revaluation of fixed assets.
Relating the profit and loss account to the balance sheet, a shareholder could look to see the return a company was producing on shareholders' funds - profits after tax as a percentage of shareholders' funds. Again look for a steady performance. There is a wide range of information which shareholders can use to assess company performance. But the first step for any investor must be to understand what each company invested in does, its strengths and weaknesses and the threats and opportunities in its environment.
