Economist guide to analysing companies

321 Pages·2007·1.38 MB·English

GUIDE TO ANALYSING COMPANIES
OTHER ECONOMIST BOOKS
Guide to Business Modelling
Guide to Business Planning
Guide to Economic Indicators
Guide to the European Union
Guide to Financial Markets
Guide to Management Ideas
Numbers Guide
Style Guide
Dictionary of Business
Dictionary of Economics
International Dictionary of Finance
Brands and Branding
Business Consulting
Business Ethics
Business Strategy
China’s Stockmarket
Dealing with Financial Risk
Globalisation
Headhunters and How to Use Them
Successful Mergers
The City
Wall Street
Essential Director
Essential Economics
Essential Finance
Essential Internet
Essential Investment
Essential Negotiation
Pocket World in Figures
GUIDE TO ANALYSING
COMPANIES
Bob Vause
THE ECONOMIST IN ASSOCIATION WITH
PROFILE BOOKS LTD
Published by Profi le Books Ltd
3a Exmouth House, Pine Street, London ec1r 0jh
www.profi lebooks.com
Copyright © The Economist Newspaper Ltd 1997, 1999, 2001, 2005
Text copyright © A. H. Vause 1997, 1999, 2001, 2005
All rights reserved. Without limiting the rights under copyright reserved above, no
part of this publication may be reproduced, stored in or introduced into a retrieval
system, or transmitted, in any form or by any means (electronic, mechanical,
photocopying, recording or otherwise), without the prior written permission of both
the copyright owner and the publisher of this book.
The greatest care has been taken in compiling this book.
However, no responsibility can be accepted by the publishers or compilers
for the accuracy of the information presented.
Where opinion is expressed it is that of the author and does not necessarily coincide
with the editorial views of The Economist Newspaper.
Typeset in EcoType by MacGuru Ltd
Contents
Introduction vi
Part 1 Understanding the basics 1
1 The annual report – and what underlies it 3
2 The balance sheet 30
3 The income statement 61
4 The cash flow statement 89
5 Other statements 111
Part 2 Assessing the facts 115
6 Guidelines for financial analysis 117
7 Measuring profitability 129
8 Measuring efficiency 157
9 Working capital and liquidity 178
10 Capital and valuation 205
11 Strategy, success and failure 235
Part 3 Useful benchmarks 267
12 Practical examples of ratio analysis 269
Glossary 292
Index 293
Introduction
he aim of this book is to provide an understanding of how to
Tanalyse and assess the performance of a company from the infor-
mation provided about it.
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 a constructive attempt can be made to analyse a com-
pany, a sound grasp of financial terminology and presentation is
required. Thus Part 1 of this book explains the content and intent of the
main financial statements that appear in a company’s annual report: the
balance sheet; the income statement or profit and loss account; and the
cash flow statement.
All countries and companies share the basic accounting framework
used in the production of financial statements, but the presentation of
them is not standard. Adjustments may have to be made, but the outline
provided in Part 1 is applicable to any company and any country. Some
explanation of differences between US, EU and UK reporting practices is
offered; translations of some of the terms found in European financial
reports are given in a glossary in Part 3.
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 is grasped there should be no problem in moving to
more detailed and sophisticated analysis. In general, the book’s exam-
ples focus on retail, service and manufacturing companies rather than
banks and other financial institutions, which are subject to different
legal and reporting requirements.
Part 2 of the book deals with the various methods of analysing dif-
ferent aspects of corporate performance. However, three important
ground rules apply to each of these methods:
1 Never judge a company on the basis of one year’s figures. Always
look at three or, ideally, five years’ figures.
2 Never judge a company in isolation. Always compare its perform-
ance with others of the same size and/or the same business sector
and/or country.
3 When comparing companies always make sure, as far as you can,
vi
INTRODUCTION
that you are comparing like with like – in other words, that the basis
of the data being analysed is consistent.
Profit and finance are two broad strands interwoven in the overall
management of successful business organisations today. They also pro-
vide the basis for the analysis of a company. Each strand is equally
important and both must be followed. Analysing a company’s prof-
itability without any reference to its financial position is of little value.
Similarly, there is little point in doing a detailed analysis of a company’s
financial structure without reference to its performance. Profit is not suf-
ficient on its own; a company must have the resources to allow it to con-
tinue in business and flourish.
To achieve an acceptable level of profit necessary to satisfy share-
holders’ requirements – to add value – is a common corporate objective.
Without profit there can be no dividend or share value improvement, or
reinvestment for future growth and development. A substantial part of
this book focuses on various ways of identifying and measuring prof-
itability. Shareholder value is more than just annual profit, and not
everything is capable of quantification. Future expectations of a com-
pany’s performance outweigh its track record in determining its share
price – a factor that probably offers as good an indicator as any of share-
holder satisfaction. Chapter 6 offers some general guidelines for under-
taking the practical analysis.
When the practical analysis of a company is completed, the tables
in Part 3 offer some benchmarks against which the ratios explained in
Part 2 can be tested or 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 provide an indicator of whether this is good, bad or indiffer-
ent. That can only be determined by applying the three rules stated
earlier.
An important lesson from the 1990s 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. In all probability it is not a failure of your
analytic ability but someone practising corporate legerdemain.
The major change on the horizon is the adoption of international
accounting standards (ias) of corporate reporting. Already progress
has been made. All European Union listed companies now apply ias
in their reports. Allied to this, the internet will continue to improve the
vii
GUIDE TO ANALYSING COMPANIES
private investor’s ability to access and analyse detailed and up-to-date
performance and position figures.
As far as possible the book is written with a light touch. Companies
get their momentum from people, whereas financial analysis of their
activities is an art. Art combined with people should be fun; if it is not
then you should leave it to those who enjoy it.
viii
1
UNDERSTANDING THE BASICS