Fool School

How to read an Annual Report in 5 minutes

Novice investors often have great stock ideas but are nervous of actually buying shares in the company because they profess to be baffled by the company's accounts. So many people are put off by the very document that is supposed to help them: the annual report. It is usually thick, heavy, full of pompous photographs of the board and, worst of all, half of it contains seemingly incomprehensible numbers.

But don't panic: reading an annual report is actually very, very easy. For a start, you treat it like the Financial Times: start at the back and work forward. The data you really want is often tucked away in notes to the accounts, and they are at the back. Don't forget the aim of this exercise is to get the information you want; not the propaganda the company wants you to believe. That means you can skip the whole of the front section. That cuts the job in half to start with.

In this exercise we are assuming you only know two things to start with: what the company does and what the share price is.

Getting started

So the first piece of data we need is the number of shares in issue. This crucial piece of information is never clearly displayed in the accounts, but you need it to work out the most important number in the whole exercise: the market capitalisation of the company. This is the value that the stock market is putting on the equity of the company. You can calculate it by multiplying the share price by the number of shares in issue. But where do you find the number of shares in issue?

It's not that difficult. Go to the financial statements in the middle of the accounts. Look at the page called "Consolidated Balance Sheet" and then run your eye down the left-hand column labelling the lines until you get to one that says "Called-up Share Capital". Track right to a column titled "Notes". There you will see a number. Remember that number. Flick forward in the accounts to find that very same number, and a subtitle next to it that says "Share Capital". In the text here you will probably see a table that says "Issued Capital" and a very large number, generally between 10 million and a billion or so. Make sure it is the number for this year and not last and that, dear Fool, is the number of shares in issue. Write it down in large numbers on the inside front cover of the accounts and multiply it by the share price to get the market capitalisation, or market cap for short. Write that down too.

We can use the market cap to work out some simple ratios. These ratios give us a guide to whether the share is cheap, expensive or perhaps somewhere in between.

The Price to Book Ratio

First, let's go back to the balance sheet and, at the bottom, find the line that says Shareholders' Funds (make sure you look at the column for the most recent year). This is simply a number that is an accurate historical record of how much money the company has raised, and how much has been added to it by profits or reduced by dividends paid out or losses incurred. In some companies it is meaningless, but in other companies it can be an interesting guide. Cynics would say that, like most accounting numbers, it is 100% accurate and 100% useless.

Anyway, divide this number into the market cap. Normally the answer will be above 1, probably around 3 or 4. That means the stock market thinks the company is worth 3 or 4 times what the accountants calculate. That is not always an infallible guide, but it is a start. Any company with a price to book (as this number is known) lower than 1 may be worthy of further investigation. This ratio is most useful for traditional manufacturing companies. It is less useful for people-based businesses.

The Price to Sales Ratio

Next, go to the page before the balance sheet -- it's usually on the left-hand side facing it -- titled Consolidated Profit and Loss Account. The first line of the column will give you the sales figure, or turnover, for the last financial year. There will usually be a couple of lines around it giving adjustments for various things. Ignore those and focus on the number that is given the most prominence, either by being bolded, or by being positioned below a line.

Take this number and divide that into the market cap. The result will normally be a number between 1 and 5. This is the Price to Sales Ratio. If it is below 1 that could indicate that the company is cheap. If it above 5 it is more expensive. A high Price to Sales Ratio is not a problem if the company is in a fast-growing industry, and you can check that quite easily by calculating the percentage rise in sales from the previous year. Subtract the previous year's sales from last year's sales and divide the difference by the sales of the earlier year. Most companies should be growing at close to nominal GDP growth, say 5%. Anything less than that is verging on stagnant and anything more warrants further attention.

The Profit Margin

How much profit does a company make for each pound of sales? Looking down the Consolidated Profit and Loss Account you will see a variety of different profit numbers. You can work out a profit margin on any of these. But the easiest one to use is profit after tax. This is how much profit is left for shareholders after everyone else has had their slice. Divide profit after tax by the sales figures you used above. This is the profit margin, and it is usually expressed as a percentage. The higher the better. Companies with margins of over 15% are usually strong businesses. Low profit margins, below 5%, may indicate a competitive industry. You can also calculate last year's profit margin to see what the trend is. Obviously, we prefer businesses where profit margins are rising.

The Price to Earnings Ratio

Before we leave the Profit and Loss Account we have one more calculation to make. Take the reported net profit for the last financial year and divide that into the market cap to give you the historic price to earnings ratio (or P/E ratio). It should be the same as dividing the share price by the earnings per share, but it is good to get into the habit of looking at the company rather than the share. That ratio will probably be around the high teens. The average for the UK market is around the mid-twenties, but is distorted by some stocks with particularly high P/E ratios. Anything less than the mid-teens may warrant further investigation, especially if profits have been steadily rising year after year.

Cash or debt?

Now we leave the profit and loss account. We need to get an idea of how soundly financed this company is. In other words, how much debt does it have? Or does it have surplus cash? We can work this out from the Balance Sheet, but we need to combine a number of different figures. But there is a short cut. Either next to the Cash Flow Statement or towards the end of the notes to the financial statements you should see a short section called "Analysis of Net Cash/Debt". This combines all the company's cash and debt into one net figure, saving you the trouble of doing additional sums.

If the company has net cash then that indicates that its finances are reasonably healthy. If it has net debt, we need to dig a little deeper. Divide the net debt number by the Shareholders' Funds figure you looked at earlier. This is known as the Gearing Ratio. A figure or 1 or more indicates that the company has a serious amount of debt. A normal figure would be about one-third.

How does the cash flow?

Now we know how much cash a business has we only need to find out one more thing. How much cash is the business generating on a yearly basis? Firstly, we need to calculate the company's Enterprise Value. This is simply its market cap plus its net debt or minus its net cash.

At the very top of the Consolidated Cash Flow statement will be a line titled Operating Cash Flow. Just have a look at it. Is it much bigger than profit before tax figure in the Consolidated Profit and Loss Account? It should be. Is it bigger or smaller than Capital Expenditure, which you can find a little further down, and is it comfortably bigger than the dividend payments, which will be about two-thirds of the way down? The last exercise you do is to divide that operating cash flow into the enterprise value. This ratio tells us how many years of cash flow are required to equal the total value of the company and is a good measure of how "cash-generative" a company is. Any number below 5 would make the company appear cheap, and a number over 10 would be on the expensive side.

That's all, folks!

If all that takes more than 5 minutes the company has got poor accounts, and that degrades it as an investment. And remember, of course, that this is only the first step. There are lots more things you can do with the numbers, and there are some next steps listed below if you want to dig a bit deeper. The simple ratios we have covered here will give you a good snapshot of the financial structure, strength and growth rate of the company.

To finish, here's a quick recap of those key numbers:

Market Cap            = number of shares x share price
Price to Book         = market cap / shareholders' funds
Price to Sales        = market cap / annual sales
Profit Margin         = profit after tax / annual sales
P/E ratio             = market cap / profit after tax
Gearing               = net debt / shareholders' funds
Enterprise Value (EV) = market cap plus debt (or minus cash)
EV / cash flow        = Enterprise Value / operating cash flow