The reality behind the figures can be problematic but an accurate picture of a firm's wellbeing starts with the notes, writes Sharon Smith
Company accounts can promise an Aladdin's cave and deliver Mother Hubbard's cupboard. A company seemingly wallowing in profits can go broke tomorrow.
This is because companies can legally manipulate their figures to present the best picture. You need to ferret beneath the surface to ascertain whether the accounts give a true picture of a firm's financial health.
The first point to grasp is that statistics are useful only when compared with one another, and with those of rival companies and the sector in which they are operating. You need to look for trends over time, using ratios and margins which can be calculated from the profit and loss account (P&L), balance sheet and cash-flow statement.
Cash-flow is considered the most honest measure because whereas profits can be manipulated and balance sheets configured to show their best face for one day out of 365, cash is difficult to fiddle. However, Peter Elwin, head of accounting and valuation research at Cazenove, warns: "There is no one killer ratio that will give you the answer and there's quite a lot of danger in terms of just fixing on one statement.
"You need to look at all three financial statements and you need to understand the links between them and to try to reconcile one to another."
The second point to grasp is that you ignore those reams of notes attached to the accounts at your peril.
Alistair Hodgson, investment manager at private client stockbroker Pilling & Co, says: "I almost look at the notes more than I look at the main figures at first. The notes tend to hold the key to anything that looks strange.
"I look to pick out things that the auditor has told the company to declare - the kind of thing they might not want to declare, but they have got to do so in order to make the accounts honest."
The notes explain the statistics and the way they are calculated. If accounting practices change you need to find out why. For example, a company can extend its assets depreciation period to flatter pretax profit.
Also buried in the notes will be potentially lethal time bombs such as contingent liabilities - potential litigation expenses or financial burdens imposed by other companies and other off-balance sheet debt, including the cost of certain types of lease. Enron was a past master at hiding massive debt off the balance sheet.
You want to see a company increasing its turnover and profits while making enough cash to sustain such growth. You need to compare this year's figures with at least four previous years.
From 2005 companies must use a new accounting procedure called IFRS (International Financial Reporting Standards) which renders such comparisons more time-consuming.
But the bonus is that under IFRS companies have to better clarify how much pension liabilities, derivatives, acquisitions and share options are really costing shareholders.
A firm can be awash with profits but dying from lack of cash. You need to compare operating profit from the P&L account to how much cash is passing through the company on the cash-flow statement.
If there is a wide or worsening discrepancy, find out why. There might be less cash than profit because the company has increased working capital or asset investment to promote growth. But it might be because profits are being manufactured, stock is hanging around or debtors are not paying.
Even if the company is investing for growth, it needs to do so wisely and its cash burn rate - how fast it spends - must not put it in danger of running out of cash.
Its debts must be met with enough financing, preferably from cash generated by operations rather than resorting to more loans or relying on shareholders to bail it out.
Dividends are a good sign, says Jonathan Harbottle at Liontrust Asset Management: "If a company manages to pay out a bigger dividend each year then, in our view, that's a sign of health."
Hodgson also advocates checking out directors' shareholding: "It would be a negative scoring if they had a whole bunch of directors who had been appointed years ago and had adequate time and resources to invest and had not done so."
Finally, don't forget the chairman's statement, says Hilary Cook, director of investment strategy at Barclays Stockbrokers. "The most interesting thing of all is usually how the chairman's statement has changed," she says.
"What you often find is that the chairman will change his emphasis on how they're doing and on how different bits are doing and it's very interesting to read one year over the next.
"A good company will deliver a very consistent message."
Moreover, read the report through to the bitter end so as not to miss the bit where the chairman qualifies the preceding gloss with an admission that future trading will be tough.
KEY RATIOS
Ratios can differ in how they are calculated, so check you are comparing like with like. They need to be used in conjunction with one another and compared with competitors' and sector ratios. They are not a foolproof measure of a company's health but will highlight trends and danger zones.
PROFIT RATIOS
Operating/gross margin: turnover divided by operating/gross profit. Look for rising trend.
Interest cover: operating profit divided by interest charge. A measure of how well a company can pay its debts, you want a cover of at least four.
Cash interest cover: cash operating flow divided by interest. Regarded as a better ratio because it is measured against cash.
Price/earnings ratio (p/e): share price divided by earnings per share. Regarded as a key ratio because a company's earnings affect its share price.
Dividend yield: share price divided by dividend.
Dividend cover: earnings per share divided by dividend. Measures how much the company can cover its dividend payments. Look for a cover of at least twice for comfort.
Cash dividend cover: operating cash flow divided by dividends paid.
EBITDA: (earnings before interest, tax, depreciation and amortisation): can flatter acquisitive companies writing down large amounts of goodwill. But Alistair Hodgson, investment manager at stockbroker Pilling & Co, advises flexibility, citing Vodafone as a company that has written down high amounts of goodwill over its purchase of new 3G technology.
"It might well be that after a couple of rocky years of write-downs, and I think this is the case with Vodafone, they will be an immensely cash generative business. Pile on board and see the cash machine," he says.
BALANCE SHEET/LIQUIDITY, DEBT RATIOS
Quick ratio (acid test): current assets minus stock divided by current liabilities. Gives an idea of a company's liquidity. Should be above one.
Current/liquidity ratio: current assets divided by current liabilities. Should be above one and not much below two.
Gearing: total borrowings minus cash as a percentage of net assets. A measure of a company's debt. Fifty per cent is about average, but how high is comfortable depends upon a company's ability to generate cash and pay debts.
Return on capital employed: profit before interest divided by net capital employed (total assets minus current liabilities). Compare with the sector average. Look for a rising or maintained trend.
