Understanding Business Accounting For Dummies, 2nd Edition (104 page)

Part IV

In this part . . .

T
his part looks at accounting and financial reporting from the outside investor's, or non-manager's, point of view. Outside investors in a business - the owners who are not on the inside managing the business - depend on the financial reports from the business as their main source of information about the business. Investors should know how to read and interpret the financial statements and what to look for in the footnotes to the statements. Their main concerns are the business's profit and cash flow performance and its financial health. Lenders to the business have similar interests in how the business is doing. Key ratios are calculated to test the success of the business in making profit and keeping its financial affairs in order.

Investors should also read the independent auditor's report, which provides some, though far from conclusive, assurance that the financial statements have been prepared properly. The auditor's report may reveal serious shortcomings in the statements (if they find any) and warns investors in the event that the business is standing on thin financial ice and may not be able to continue as a going concern. Investors should also look and see from a financial perspective how comparable businesses are performing.

Chapter 14
:
How Investors Read a Financial Report

In This Chapter

Looking after your investments

Keeping financial reports private versus making them public

Using ratios to interpret profit performance

Using ratios to interpret financial condition and cash flow

Scanning footnotes and identifying the important ones

Paying attention to what the auditor has to say

I
n reading financial reports, investors need to know how to navigate through the financial statements to find the vital signs of progress and problems. The financial statement ratios explained in this chapter point the way - these ratios are signposts on the financial information highway. Also, investors read financial newspapers and investment magazines, and investment newsletters are very popular. These sources of investment information refer to the ratios discussed in this chapter, on the premise that you know what the ratios mean. Most individual investors in public companies don't have the time or expertise to study a financial report thoroughly enough to make decisions based on the report, so they rely on stockbrokers, investment advisers, and publishers of credit ratings (like Standard & Poor's) for interpretations of financial reports. The fact is that the folks who prepare financial reports have this kind of expert audience in mind; they don't include explanations or mark passages with icons to help
you
understand the report.

Why should you bother reading this chapter if you rely on others to interpret financial reports anyway? Well, the more you understand the factors that go into interpreting a financial report, the better prepared you are to evaluate the commentary and advice of stock analysts and other investment experts. If you can at least nod intelligently while your stockbroker talks about a business's P/E and EPS, you'll look like a savvy investor - and may get more favourable treatment. (P/E and EPS, by the way, are two of the key ratios explained later in the chapter.)

This chapter gives you the basics for comparing companies' financial reports, including the points of difference between private and public companies, the important ratios that you should know about, and the warning signs to look out for on audit reports. Part II of this book explains the three primary financial statements that are the core of every financial report: the profit and loss account, the balance sheet, and the cash flow statement. In this chapter, we also suggest how to sort through the footnotes that are an integral part of every financial report to identify those that have the most importance to you. Believe us, the pros read the footnotes with a keen eye.

Financial Reporting by Private versus Public Businesses

The main impetus behind the continued development of generally accepted accounting principles (GAAP) has been the widespread public ownership and trading in the securities (stocks and bonds) issued by thousands of companies. The 1929 stock market crash and its aftermath plainly exposed the lack of accounting standards, as well as many financial reporting abuses and frauds. Landmark federal securities laws were passed in the US in 1933 and 1934, and a federal regulatory agency with broad powers - the Securities and Exchange Commission (SEC) - was created and given jurisdiction over trading in corporate securities. In the UK, the Department for Business Enterprise and Regulatory Reform has enacted a series of Companies Acts, culminating in one consolidated act in 2006, that have strengthened the protection for shareholders. Financial reports and other information must be filed with The London Stock Exchange or the relevant authorities elsewhere, such as the SEC in the US, and made available to the investing public.

GAAP are not limited to public companies whose securities are traded on public exchanges, such as the London and New York Stock Exchanges and NASDAQ. These financial accounting and reporting standards apply with equal force and authority to private businesses whose ownership shares are not traded in any open market. When the shareholders of a private business receive its periodic financial reports, they are entitled to assume that the company's financial statements and footnotes are prepared in accordance with GAAP. If not, the chairman or other chief officer of the business should clearly warn the shareholders that GAAP have not been followed in one or more respects. Of course, such a warning might be like waving a red flag and cause the owners to demand an explanation.

The bare-bones content of a private business's annual financial report includes the three primary financial statements (balance sheet, profit and loss account, and cash flow statement) plus several footnotes. We've seen many private company financial reports that don't even have a letter from the chairman - just the three financial statements plus a few footnotes, and nothing more. In fact, we've seen financial reports of private businesses (mostly small companies) that don't even include a cash flow statement; only the balance sheet and profit and loss account are presented. Omitting a cash flow statement violates GAAP - but the company's shareholders and its lenders may not demand to see the cash flow statement, so the company can get away with violating the GAAP rules.

Publicly-owned businesses must comply with an additional layer of rules and requirements that don't apply to privately-owned businesses. These rules are issued by the Stock Exchange, the agency that regulates financial reporting and trading in stocks and bonds of publicly-owned businesses. The Stock Exchange has no jurisdiction over private businesses; those businesses need only worry about GAAP, which don't have many hard-and-fast rules about financial report formats. Public businesses have to file financial reports and other forms with the Stock Exchange that are made available to the public. These filings are available to the public on the London Stock Exchange's Web site
www.londonstockexchange.com/
or for US companies on the Securities Exchange Commission's (SEC's) EDGAR database at the SEC's Web site -
www.sec.gov/edgar/quickedgar.htm
.