How to read company accounts

Every one of us, no matter how mathematically challenged, has the potential to be an accountant.

That may delight or horrify you. But, if you're serious about getting the best from the stock market, then it's good news indeed.

Crunching a few numbers is still the best way to work out old-fashioned investment indicators like company profitability, viability and whether shares are fairly priced.

The place to find this sort of thing out is the company accounts, sometimes called the results or financials.

And contrary to what you might think, once you understand what you're looking for, these accounts can make for enthralling reading.

To help you we've put together this basic guide to making sense of company accounts.

Please note, this is a rough guide (it ignores technicalities in favour of simplicity) and is not exhaustive.

Also, there are going to be quite a few financial terms.

Most will be explained as we go along, so don't be put off.

If you are not familiar with a term and it is not explained, try looking at our A - Z of financial terms in the Guides and Factsheets section.

Lastly, if you can get hold of a company account, it will be a helpful visual aid to understanding the guide.

The Balance Sheet

The balance sheet tells us how much a company is worth, how healthy it is and whether its shares reflect these factors.

It deals with two concepts: what a company owns (its assets) and what it owes (its liabilities).

Assets basically come in two flavours: fixed and current.

As a rule-of-thumb fixed assets are anything that will be around for a long time, like factories and land, trademarks and money already spent on research. Current assets are things that have a shorter life-span, like stock and cash in the bank.

Crunching a few numbers is still the best way to work out old-fashioned investment indicators like company profitability, viability and whether shares are fairly priced

Liabilities also have two guises: long-term and current. Quite simply, money not due to be repaid in the next year is considered to be a long-term liability. Money due within the year is, therefore, a current liability.

Is the company solvent?

One of the simplest things you can discover from the balance sheet is how likely it is that the company will still be here this time next year.

Remember companies go bust because they run out of money, not because they can't sell their products.

Take a second to divide current assets by current liabilities.

This is called the liquidity ratio - anything less than one and your company is facing a cash crunch.

Better still, take current assets and remove the value of stock, which is difficult to shift in an emergency, then divide that figure by current liabilities.

This is known as the acid-test ratio, and is considered to be the best crude test of a company's short term viability.

How much is it worth?

Another simple but powerful fact tucked away in the balance sheet is how much a company is physically worth. Or, to use the proper term, its net asset value (NAV).

NAV is total assets (fixed and current) less total liabilities (long-term and current).

Most commonly you'll see NAV expressed as a function of a company's shares, as in NAV per share. This is simply NAV divided by the number of shares in issue.

If you work out a company's NAV per share, you will notice it does not equal its actual share price.

This is because the stock market, which sets the latter, factors in expected profit as well as NAV when setting its price.

If the share price is higher than the NAV per share then the market is expecting a company to make future profits.

But an NAV higher than the share price could spell bad news.

The Profit and Loss Statement

The next account we come to is the profit & loss statement (P&L). This is much the same as the balance sheet in terms of information.

The difference between the two is a matter of timing.

The balance sheet is a snapshot of a company's financial position on a given day. The P&L records performance over a period of time - either a quarter-year, half-year or full-year.

How much is it making?

The first number you will come across on the P&L is turnover. This is the value of a company's sales.

Take away the cost of sales, which will appear just below, and you get gross profit.

This figure in isolation doesn't tell you much, but compare it against previous years' gross profits and you get an idea of the direction company profits are heading.

A better indicator of profit is earnings before interest, tax, depreciation and amortisation, or EBITDA.

This sounds complex but it's simply a matter of subtracting administrative expenses - the next number on your P&L - from gross profit. A healthy EBITDA figure is a good indicator of whether a company has a future.

What are depreciation and amortisation?

The next figures on the P&L will be depreciation and amortisation (the DA in EBITDA). These put a figure on how much value a company's assets have lost over a period of time.

This might sound like a strange concept but it makes sense. Imagine a company buys a new factory that it plans to use for 10 years. Why should it have to attribute all the cost of that factory to the year it was purchased?

Depreciation and amortisation allow accountants to stretch this expense over the life of an asset. This gives a truer indication of its cost against each year's production.

Depreciation refers to the falling value of fixed assets, things like factories and other machinery.

Amortisation refers to intangible assets, like research spending, trademarks and goodwill.

Operating profit and the bottom line

Once the cost of depreciation and amortisation is factored in, you finally arrive at operating profit, or EBIT (earnings before interest and tax).

This is the amount of money a company has made from its business activities over the period covered by the P&L.

But operating profit is still not the fabled bottom line.

To arrive at that you have to take into account a company's financing activities, which include interest earned or paid, exceptional items and of course tax.

Exceptional items are large non-recurring expenses or windfalls that are subtracted or added to company profit.

When reading an account it is worth taking a close look at these exceptionals.

The definition of exceptional items is flexible and companies can play pretty loose when it comes to massaging the books to their own end.

The figure that is left, after a company has subtracted interest and exceptional items from operating profit, is the number that the taxman is interested in.

The ins and outs of company tax are complex, so you will have to dig into the notes to the accounts to find out why a company paid the tax it did.

You will find these notes-to-the-accounts at the back of the accounts. The little numbers you will see next to items in the accounts are references to the specific note that explains that item.

Are we there yet?

Having accounted for taxation we finally reach the bottom line, otherwise known as profit after tax or net income.

This is the money that is paid to shareholders as dividends and/or kept by the company as retained profit.

What is a cashflow statement?

And so to the last part of the accounts that merits our attention, the cashflow statement.

This tells us how much money is running through a company at any time.

Cash is the fuel that keeps a company sparking. Unless there is a steady flow coming in then it will soon stall.

The cashflow statement runs through three basic stages.

First it tells us how much money is coming in from operating activities.

As a rule-of-thumb this is operating profit, excluding depreciation, amortisation and some exceptional items. These are taken out because they are accounting tricks, not real cashflows.

Next the company will add or subtract cashflows from non-business activities.

This includes a raft of things that don't relate to the day-to-day business of the company, things like interest payments on loans (often called servicing of finance), dividend payments to shareholders and tax.

Finally cashflows from financing are taken into account.

These will include things like money raised from share sales and money brought in as a result of loans.

All this will leave you with a net increase or decrease in cash.

The end

Voila! There you have it. A good understanding of the basics of a company's accounts.

Happy reading!