UNDERSTANDING ACCOUNTS

Once you have found or been supplied with some accounts, you then have to make sense of them.

The accounts filed at Companies House will be in a standard format and include:

• Auditor’s opinion – where required in larger companies, which should be a ‘clean’ opinion that the auditor is satisfied that the accounts represent a true and fair view of the company’s position. Any qualification of this opinion should be a matter of extreme concern.
• Profit and loss account (or ‘P&L’ account) a statement of how the business has traded over the period of the accounts and shows how much profit (or loss) has been generated. Unfortunately, smaller companies do not have to file a P&L account.
• Balance sheet – a snapshot at the end of the year of the company’s assets and liabilities, although confusingly you cannot rely on this to provide you with an accurate reflection of the market value of all the types of assets at the year-end (for the reasons for this see Chapter 9).
• Notes to the accounts – which are vital to be able to understand the P&L and balance sheet, as for example these will include details of the company’s accounting policies such as depreciation, which will affect both the profit for the period and the book value of the fixed assets at the period end.

In addition, some companies will attach a detailed P&L to the back of their accounts. Since the standard P&L included in the accounts filed actually shows very little information about the business’s costs, I would recommend that even if you are not interested in that particular company, you should keep the example for use in later benchmarking of any targets where you obtain detailed accounts.

HOW ARE ACCOUNTS PREPARED?

The accounts which you will find filed at Companies House are prepared from the company’s books and records in accordance with UK GAAP.

If you’re not familiar with accounting practice there are two key underlying concepts that you need to be aware of to make sense of any set of accounts. These are the fundamental concepts of:

• prudence
• matching (also known as the ‘accruals’ basis).

Prudence

Accounts should be prepared prudently. This means firstly that they should not anticipate profit before it’s been earned, so sales should not be recognised in turnover until the goods or services have been supplied and normally the invoice raised. At the same time losses should be recognised as soon as possible by providing for the costs or writing down any asset whose value has been impaired as soon as appropriate.

Matching

Accounts should also be prepared on the basis that costs should be matched to the relevant sales or periods. So for example if the company has bought three widgets during the year and has sold two of them, then the cost of the two that have been sold will appear in the profit and loss account as the costs of the goods sold, thereby matching the cost to the relevant sales during that period. The cost of the third will be carried forward as part of the stock in the balance sheet to be matched against the sales proceeds when it is sold at some point in the future.

In the same way, overhead costs should be matched to the relevant periods. So, for example, if the company is billed quarterly in arrears, for electricity but the year-end to which the accounts are drawn up comes two months through a quarter, then the company should accrue a cost in profit and loss and a liability in creditors (shown as an accrual) for two-thirds of a normal quarter’s electricity bill.

This principle operates in reverse as well in that if, for example, the company has paid an insurance premium in January covering the 12 months of the calendar year, but it draws up accounts to the end of June, then it has actually paid six months of the following accounting year’s costs during the current year. This is then dealt with by deducting half of the insurance premium paid from the cost in the profit and loss account, and showing this balance as an asset called a prepayment as part of the business’s current assets, under the overall heading of debtors.

WHAT IS IN EACH PART OF THE ACCOUNTS?

Profit and loss account (P&L)

The company’s profit and loss account will be made up of:

• turnover – the company’s total sales that relate to the period (net of VAT)
• costs of sales —the costs to the company in buying in materials or producing things, of the goods or services that have been sold which make up the turnover
• gross margin or gross profit – the profit that the company has ade by selling the goods or services, before having to pay overheads
• overheads – the general costs that the company incurs by being in business (such as audit fee)
• net profit – the profit that the company has left after covering the overheads out of the gross profit.

You will find that the accounts may look slightly more complicated than this because, for example, interest and other financial charges will be set out separately while profit will be shown before and after tax.

Balance sheet

The company’s balance sheet will consist of:

• fixed assets – such as property, plant and machinery or motor vehicles which the company owns and will use over a number of years
• any investments – in subsidiary companies
• current assets – such as debtors (or to use the American term, receivables), stock and cash in hand and at the bank
• current liabilities – all the creditors (or payables, in American parlance) which are due and payable within the next 12 months. This will include normal trade creditors, balances due to the Crown in respect of VAT or PAYE, the proportion of the capital of long-term loans, HP and leases that are due to be paid during this period, and the total of any bank overdraft as these are always repayable on demand
• long-term liabilities – all creditor balances due after longer periods than a year.

Net assets

The current assets and current liabilities form the working capital of the business, while the net assets is the sum of the fixed and current assets and investments, less the current and long-term liabilities.

The value of the net assets (which should be a positive number) will then match the value of the shareholders’ funds, which consist of:

• the share capital – the funds introduced to the company by the shareholders
• the retained profits (or the P&L account) – which is essentially the sum of money left in the business from profits over the years
• any other reserves – such as will have been created by a revaluation of the company’s property.

Notes to the accounts

The notes to the accounts will cover a number of areas such as giving more detailed breakdowns of the fixed assets, debtors and creditors. Particular notes to look out for are:

• The accounting policies, which set out some information as to how the accounts have been prepared such as the depreciation policy. You should ask yourself whether the policies set out seem reasonable for the business. If not, why not? Also be on the lookout for any changes in accounting policy, as this can be a means of manipulating the apparent profitability of the business. For example, depreciating a piece of machinery costing £100,000 over three years gives a cost of depreciation in the P&L of £33,333 per year. Changing the period to five years reduces this cost to £20,000 per year, and gives an instant profit improvement of £13,333 per year.
• Any note about contingencies is a warning that there are some potential liabilities such as outstanding warranty claims or perhaps legal proceedings which haven’t been shown in the accounts as they are not considered likely enough in the current directors’ judgement to need to be provided for. Your judgement might, however, be different.
• Anything about a ‘defined benefit’ or ‘final salary’ pension scheme, which is one where employees’ pensions are determined by length of service and their salary at retirement. In the aftermath of the Maxwell affair, the regulations to protect employees’ pensions have become more stringent, with strict duties and timescales in respect of the payment across of pension contributions. New pensions legislation is becoming ever more draconian and tending towards making company directors as well as trustees potentially personally liable in the event of any shortfall in the fund for defined benefit schemes. It may be an oversimplification but if the business you are looking at has a defined benefit pension scheme, think very carefully before you consider buying it.

WHAT SHOULD YOU LOOK FOR IN THE ACCOUNTS?

The three key areas that you should measure and understand are:

• Profitability – does the business make money?
  • horizontal and vertical analysis
  • types of cost
  • gross profit, contribution and break-even
  • cost drivers
  • profit improvement
  • breaking the business down

• Financial stability – how risky are the finances?
  • liquidity
  • gearing

• Financial efficiency – how well is the business managing the cash it needs?
  • stock turn and debtor and creditor days
  • the working capital cycle
  • source and application of funds
  • return on investment.

UNDERSTANDING PROFITABILITY

Horizontal and vertical analysis

As a starting point in understanding any set of P&L accounts, ‘horizontal’ and ‘vertical’ analysis can be used to spot the trends in turnover and costs over time.

In horizontal analysis you treat year one as your base point of 100% and express the numbers in other years as percentages so that the level of change can be easily seen. This type of approach shows how revenues and costs are changing over time (but you must be careful to adjust for inflation effects over longer periods).

In vertical analysis you express the figures for each element of the P&L as a percentage of that year’s sales. This shows how much of the business’s sales each category of expenditure is consuming in each year.

In the example above, from horizontal analysis you would want to know why general overheads have grown by 50% in three years.

But from the vertical analysis you can see that even so, general overheads are only 13% of sales. The more immediate issue is the increase of cost of sales to 58% of sales, from 50%.

This process can help you familiarise yourself with the company’s performance and start to indicate some areas to investigate, particularly if you have information from other companies in the same sector against which to benchmark performance.

When benchmarking, use vertical analysis, which enables you to compare the relative percentages of different types of cost between businesses of different levels of turnover and see what that might be telling you about their relative levels of efficiency.

Types of costs

To really understand a business’s profitability, you must, however, first understand the cost structure. There are essentially three types of costs for any business.

	Variable Fixed level of cost varies directly with level of production	Fixed do not vary in the short term as production fluctuates
Direct costs relate directly to the cost of producing goods for sale	raw materials piecework wages overtime pay factory energy costs	normal factory wages machinery costs and depreciation factory rent
Indirect costs general costs of being in business, not directly related to particular costs of production	—	auditors’ fees sales staff’s wages directors’ fees

Fixed costs are of course not fixed in the long term (you can move factory or hire and fire factory staff) and will eventually reflect levels of production and activity.

The profit and loss account will, however, divide costs into only two broad areas:

• costs of sales (CoS) which will include all variable direct costs
• overheads which will include all fixed indirect costs.

Businesses differ as to how they deal with analysing direct fixed costs between costs of sales and overheads.

If they do not include all their direct costs in calculating their cost of sales, they risk underestimating their costs when it comes to setting prices or tendering for contracts. The result for companies of continuously selling at less than their true cost of manufacture (i.e. at a loss) is inevitably failure. It is generally best practice therefore to include direct costs as fully as possible in establishing costs of sales.

If the company’s production volumes swing significantly between periods, however, you will need to be careful in using costs of sales to establish a meaningful ‘contribution’ figure for sales, and you may find it best to treat all fixed costs as overheads for the purpose of calculating break-even levels (see below).

Gross profit and break-even

One of the principal reasons that an understanding of the cost structure is important is the value of the gross profit and gross profit percentage, as these are used to calculate break-even.

The above break-even has used ‘accounting figures’ based on costs taken from the profit and loss accounts. It is often useful to redo this exercise to calculate a ‘cash break-even’, stripping out the key costs that do not represent cash (e.g. depreciation) and replacing this with the real cash item (e.g. lease payments).

Cost drivers

The relative level of a company’s costs compared to its competitors will be due to a number of factors – some of the most common ones are listed below. If your analysis is suggesting that the business’s costs are out of line with those of its competitors these are the areas where you might look for opportunities to cut expenditure as part of your consideration of the opportunity. Be alert, however, for the common pitfalls of poorly applied cost reductions, where disruption and other problems outweigh the planned saving.

Cost drivers include:

• economies of scale – sometimes bigger is better
• capacity utilisation – the company is paying for that plant and those people, whether they are earning for it or not
• learning curves – the more it does of something, the better at it the company should become
• location – relative local costs and transportation costs
• purchasing – how good at buying is the company?
• operating efficiency
• investment – e.g. in automation or training
• waste management.

Profit improvement

As you start to think about break-even calculations, something becomes very clear. To improve profits, you can do any or all of three things:

• increase turnover
• increase margin (gross profit percentage)
• reduce overheads.

And if you can do all three, the effects multiply.

Even in your initial screening of the businesses to be looked at you need to be thinking how you might be able to improve the profitability of any business once you take it over.

For example, a good management practice for ensuring that overheads are tightly controlled is ‘zero based budgeting’ where, rather than simply taking last year’s costs and adding X% for inflation, you start with a blank sheet of paper and forecast each business cost on a line by line basis. Undertaking this exercise in respect of any business you buy is a good way to ensure that the requirement for all costs are questioned at least once a year!

Breaking the business down

To see what is happening to a business it is often helpful to break performance down by individual area (known as a ‘profit centre’), at least at gross profit and contribution level, even if it is impractical to allocate overheads separately.

UNDERSTANDING FINANCIAL STABILITY

Liquidity

Liquidity is an indication of the business’s likely ability to pay its liabilities. Quite simply it measures: Does it have enough cash?

The basic measure is the liquidity or the current ratio which divides the current assets by current liabilities:

                                

Simplistically, one would expect that a ratio of more than one would indicate financial stability, and significantly less than one would indicate problems. Whilst this is generally a safe working hypothesis, you must compare the ratio calculated against that of other businesses in the same industry, as in some sectors an apparent low liquidity is normal. As for all ratios covered in this chapter, what you need to know for any figures calculated is:

• whether for the industry, the ratio is relatively good or bad
• what the trend is over time (increasing or decreasing liquidity).

In order to generate cash at a known value, stock must first be sold. Stock is therefore less ‘liquid’ than debtors and cash and is therefore less reliable for meeting existing liabilities than these assets.

• The acid test measure of liquidity therefore excludes stock to see how readily the business can pay its immediate liabilities:

                                                                  

Gearing

Gearing measures how financially exposed the company is by looking at to what extent the business’s long-term finance is based on borrowed money rather than the shareholders’ funds or ‘equity’:

                                                               

Again, the importance of the figures lies less in the absolute number and more in how it compares to other businesses in the sector and the long-term trends.

As interest charges on long-term loans will need to be paid whatever the profits generated by the business, the higher the gearing (i.e. the greater the proportion of the business’s long-term funding that is borrowed money), the higher the ‘financial’ risk of the business.

A related measure is interest coverage, which shows the sensitivity of available profit in covering interest payments (e.g. to the bank):

                               

It is of course true to say that your purchase of this business is likely to significantly affect the level of gearing since you may end up completely restructuring the business’s finances as part of the transaction.

UNDERSTANDING FINANCIAL EFFICIENCY

Stock, debtor and creditors days

Calculating how efficiently a company’s working capital is being managed is a matter of calculating the stock, debtor and creditors days as below and comparing them to the competition. In each case you should take an average value for the assets or liability concerned.

	shows how long it is taking to ‘turn over’ stock
	shows how long on average you are taking to pay your suppliers
	shows how long customers are taking on average to pay their bills

Monitoring the working capital cycle

A business’s ‘working capital cycle’ should be a virtuous circle:

The degree to which a business requires financing in order to trade is determined by its actual terms of trade with its suppliers and customers.

Plotting these transactions over time you can see how the borrowing requirement to fund this working capital cycle is £100 over two months:

On average therefore it will be another month after the supplier wants paying for the goods before the company sells them, and a further month before, the cash comes in from customers. So company H has to fund two months’ worth of working capital from somewhere.

A bank would see this as an appropriate use of an overdraft facility which will swing back into credit as the transaction unwinds into realised profit and cash. However, in practice Company H will need to:

• agree the facility in advance with the bank
• offer some other security such as personal guarantees, as the bank will be unlikely to lend against 100% of stock value without it.

Recognising the nature of the business’s funding requirement is a critical first step to planning how you will manage its cash requirements by ‘working capital management’.

Reducing the requirement to tie up cash in working capital will mean that cash will be available to fund a higher level of trading. In this case, were you to take over this business you might be able to reduce its borrowing requirements to nil by changing its trading:

• Reduce the investment in stock and debtors, e.g.:
  • if it only bought in the widget when it had a firm order and could ship it straight out (a ‘back to back’ deal), then the debtor would pay at exactly the same time as the creditor was due
  • if it only stocked what it could sell in a month for cash.

• Replace bank lending with supplier credit by taking three months’, credit, which would match the date of receipt and payment.
• Or a mixture, e.g. take two months’ credit from suppliers and only stock items which turn over in a month.

If you are anticipating expanding the business, you will need to ensure that you put in place the finance required to cover the funding gap as this expands with it. Businesses that expand faster than the financing is able to keep up with, eventually run out of cash and fail for this reason (known as ‘overtrading’).

Statement of source and application of funds

Profitability is all very well but it is actually cash that pays the bills and sometimes it can be difficult to see whether the business is actually generating cash or not.

A statement of source and application of funds (SSAF or ‘Source & Apps’ and now more properly known as a cashflow statement) can be used to demonstrate where the money has come from (the sources) and gone to (the applications).

These are, however, notoriously difficult to get to balance and you may find it easiest to ask your accountant to prepare one for you.

The beauty of the SSAF is that it provides a link that shows what has happened to the profit generated by or introduced into the business, as shown in the simplified example below.

Return on investment

The different activities of different parts of the business will generate different levels of profit and require different levels of investment in assets. They will therefore produce different rates of return.

This sort of information can allow you to judge where the available funds for investment should be best applied to the business so as to get the greatest level of return.

Occasionally this type of analysis will suggest that you may benefit from closing some aspects of the business and redeploying resources to areas where you’ll get a high return. However, before planning to shut any operation you do need to be careful as you must ensure that you are not simply removing some contribution towards the overall overheads which will then need to be borne by the remaining parts of the business.

SUMMARY

Use this as a basic checklist of financial information to be obtained from the accounts of each business you are looking at:

	Answer	How is this changing over time?	Is this better, the same, or worse than comparable companies?
Company name		—	—
Date of accounts
Accounts audited or not?
Auditor name (if applicable)		—	—
	Answer	Changing?	Better/Same/Worse?
Is there a clean audit report?
Have there been any changes in accounting policy?
What is the turnover?
Is the business profitable?
What is its gross profit as a percentage of sales?
What are its overheads as a percentage of sales?
What is its net profit as a percentage of sales?
What is its breakeven point?
Can you see any potential profit improvements?
What is its liquidity ratio?
What is its acid ratio?
What are its debtor days?
What are its stock days?
What are its creditor days?
From a statement of source and application of funds (or cash flow statement) is the business generating or absorbing cash?