Investing in stocks – Part 3

The financial statements of a company consist of a balance sheet, profit and loss account, cash flow statement and notes to the account.  In the case of all publicly listed companies there is also included an auditor’s report (some private companies also do audits).  Strictly speaking the auditor’s report is not a part of the financial statements but is the auditor’s assessment as to the whether the financial statements give a true and fair view of the position of the company. It must be stressed that the role of the auditor is not to find if fraud exists in the company, that role belongs to senior management. 

However, it is expected that their tests may uncover weaknesses in the accounting systems that can lead to fraud.  There is still much debate about how much responsibility the auditors should bear when major problems are subsequently uncovered.  For example with the recent meltdown in the financial sector questions are asked about whether the audit companies should have detected that these assets were not adequately supported.

The profit and loss account is a statement which highlights the company’s sources of income and the expenses incurred in generating that income.  In some statements the earnings for the company may be called revenue whereas in others it may be called operating income.  Consider the following information:

                                       2007     2008     2009
Revenue (000’s)  10,000  12,000  14,400
Expenses (000’s)    7,000    9,500  13,000
Net profit (000’s)    3,000    2,500    2,000

The starting point in assessing a company’s potential is to look at the revenue line.  In our example, revenue is increasing by 20 per cent per annum which is a good sign.  The ability to grow revenue indicates that there is a demand for the goods or services being provided.  In the long term a business that cannot grow its revenue will struggle to survive.  However, if we look at the net profit line we notice that it is declining even though revenue is decreasing.  A ratio that is often used to evaluate this trend is the net profit percentage ratio which is simply Net profit divided by revenue or in our case

                           2007  2008  2009
Net profit %   30%  20.8%  13.9%

This ratio indicates the amount of profit earned from each dollar of revenue, using 2007 as an example the company earned 30 cents in profit from each dollar of revenue.  This decline in the ratio suggests that the company has either had to reduce its selling price in order to generate more revenue or has had to spend more in order to boost sales e.g. advertising.

The most important thing to remember about ratios is that one cannot choose one on which to base your assumptions.  Ratios must be taken together, should be compared over time and with other companies.  Next time we will look at some other ratios that you may encounter in the financial statements.