Personal Finance: How to read between the lines of annual reports

Investors often regard all company mail save their dividend cheques as junk. But studying a firm's annual report and accounts can pay off. John Andrew explains what to look out for.

One joke doing the rounds of the accountancy profession in the early 1970s was that a company had explored cutting postage costs by sending the shareholders' dividend cheques out with the annual report and accounts. Their research revealed that most shareholders threw the report and accounts away unread and the cheques would be thrown away with them, and the project was abandoned.

Since then companies have made great efforts to improve the quality and readability of their messages to shareholders, and with good reason. "Reports and accounts are vital in assessing the performance and financial position of a company in which you might have current or future interest," says Gill Nott, chief executive of ProShare.

Companies are obliged by law to report regularly to shareholders. It is a means by which those with a financial interest in the enterprise can judge how well or badly the business is doing. The main report and accounts are published annually following the end of the company's financial year.

They are considered an important communication as it is the main way that a company has of explaining its business to the outside world, so it is not surprising that most companies nowadays take considerable time and effort in producing the document.

Generally, they are glossy publications which contain photographs and colourful diagrams detailing the business's progress. Naturally they also contain reams of figures. However, they typically begin with narrative statements which provide a commentary on the business and financial performance of the company.

The opening section is usually the chairman's statement, which gives an overall view of what has happened over the past year, as well as some comments on the future prospects of the company.

The next narrative statement is normally the chief executive's report. This provides a detailed commentary of the performance of each part of the enterprise as well as information affecting the company as a whole. In some reports this section is called the "operating and financial review".

Normally, the directors' report follows. This contains data which has to be disclosed by law. It includes details of any charitable or political donations the company may have made as well as giving the names of the directors and their personal shareholdings.

Of course, the most important element of the report and accounts is the financial information. If you find pages of figures daunting, follow Gill Nott's advice: "At least take time to read the chairman's and chief executive's statements, which will give you a feel for future prospects. Is it optimistic, or is there a note of caution there?"

Although the financial information may look complicated, it is relatively easy to become familiar with the columns of figures. Ease yourself in by taking a look at the financial summary. This gives the financial highlights for at least the past two and sometimes up to five years. It is therefore possible - at a glance - to see the trend for profits as well as earnings, dividends and net asset value per share.

The two key financial statements are the balance sheet and the profit and loss account. The balance sheet is a snapshot of the company's situation at the end of its trading year. It shows what the organisation owns - its assets - and what it owes - its liabilities.

Most companies traded on the stock market control a number of subsidiary companies. They therefore prepare a consolidated balance sheet showing the assets and liabilities of all the businesses combined, as well as a balance sheet for the parent company.

The profit and loss account shows how much profit the company has made. It shows the turnover, which is the total sum of goods or services sold during the trading year, and the company's expenses. If income exceeds costs the company has made an operating profit, but interest earned and paid then has to be taken into account to arrive at profit (or loss) before tax. The company's tax dues, the dividends paid to shareholders and the profits retained by the business will also be shown.

Other information to look at is the cash flow statement. This shows how much cash the company has generated from the business and other sources, such selling a large asset. It also shows how much cash has been spent over the year.

Here are some points to look out for:

n Cash flow: It is vital that there is a strong cash flow as it demonstrates that the earnings are real and it helps fund the company's expansion.

n Turnover: This is another key indicator. If turnover is up profits and earnings per share should be too.

n Pre-tax profits: If a business is doing well profits and turnover should show a rising trend.

n Dividends: Many investors prefer companies which pay a steadily rising dividend. Comparing earnings per share to dividends per share over a period will reveal the company's dividend policy.

It is essential to read the notes to the accounts as these often have important information tucked away. Although report and accounts are important, you must always remember that their contents are historic. You must keep up to date through newspapers and magazines with companies' news.

`Introduction to Annual Reports & Accounts' is a simple guide with a step-by-step approach to interpreting the information. It is published by ProShare at pounds 4.95 including p&p. Orders to ProShare (UK) Ltd, Library Chambers, 13-14 Basinghall Street, London EC2V 5BQ.