Cheat Sheet

Interpreting Company Reports Cheat Sheet For Dummies (UK Edition)

You can measure an organisation’s financial health by its company report, but analysing it can be daunting. This Cheat Sheet explains the jargon in plain English to help you make sound financial decisions. Please note that this information is relevant to UK company reports.

Overview of Annual Report Elements

Annual reports can be daunting, and you may be relieved to know you don’t actually need to scour every page of one. The following list gives you the big picture on annual reports, from a UK perspective:

  • Chairman’s statement: A report from the chairman about progress during the preceding year and prospects for the future.

  • Operating review: Sometimes called the Operating and Financial Review (or OFR), this is a report by the key directors of the main divisions of the company giving management’s view on progress.

  • Directors’ report and directors’ remuneration report: These reports give information required by the Companies Act and the Stock exchange.

  • Auditor’s report: A statement by the auditor regarding the findings of their audit of the company’s books.

  • Financial statements: These include the balance sheet, income statement, and the statement of cash flows.

How to Make Sense of a Company’s Profitability Ratios

When getting to grips with interpreting a company report, you can test a company’s stock market reputation and money-making prowess using the following important formulas.

  • Price/earnings ratio compares the price of a share to earnings per share. A ratio of 10 means that for every £1 in company earnings per share, people are willing to pay £10 per share to buy shares in the company.

    Price/earnings ratio = Share price Earnings per share

  • Dividend cover shows the number of times profits ‘cover’ the dividend. So, if profits were 100 and the dividend payment was 25 then dividend cover would be 4 times. Use it to determine whether a company is paying out earnings as opposed to retaining them in the business to fund growth. You can also see how likely it is that the company will be able to maintain its dividend strategy in the future.

    Dividend cover = (Earnings per share) (Annual dividends per share)

  • Return on sales tests how efficiently a company is running its operations by measuring the profit produced per pound of sales.

    Return on sales = Profit before taxation sales

  • Return on assets shows you how well a company uses its assets. A high return on assets usually means the company is managing its assets well.

    Return on assets = Profit for the year Total assets

  • Return on equity measures how well a company earned money for its investors.

    Return on equity = Profit for the year Shareholders’ equity

  • The gross margin gives you a picture of how much revenue is left after all the direct costs of producing and selling the product have been subtracted.

    Gross margin = Gross profit Sales or revenues

  • The operating margin looks at how well a company controls costs, factoring in any expenses not directly related to the production and sales of a particular product.

    Operating margin = Operating profit Sales or revenues

How Liquidity Ratios Figure into Company Reports

If a company doesn’t have cash on hand to cover its day-to-day operations, it’s probably on shaky ground. Use the following formulas to find out whether a company has plenty of liquid (easily converted to cash) assets when you’re reading the company report.

  • Current ratio gives you a good idea whether a company will be able to pay any bills due over the next twelve months with assets it has on hand.

    Current ratio = Current assets ÷ Current liabilities

  • Quick ratio or acid test ratio shows a company’s ability to pay its bills using only cash on hand or cash already due from accounts receivable. It doesn’t include money anticipated from the sale of inventory and the collection of the money from those sales.

    Quick ratio = Quick assets ÷ Current liabilities

  • Income gearing lets you know whether a company is bringing in enough money to pay the interest on whatever outstanding debt it has.

    Income gearing = Interest paid divided by operating profit

  • Cash flow coverage ratio finds out whether a company has enough money to cover its bills and finance growth.

    Cash flow coverage ratio = Cash flows from operating activities ÷ cash requirements

Understanding Cash Flow Formulas

When studying a company report, use the following formulas to make sure a company has plenty of cash to keep operating so you can make a profitable investment decision.

  • Free cash flow shows you how much money a company earned from its operations that can actually be put in a savings account for future use.

    Free cash flow = Cash provided by operating activities – Net cash used in investing activities – Dividends paid – Interest paid – Tax paid

  • Cash return on sales looks specifically at how much cash is being generated by sales.

    Cash return on sales = Cash provided by operating activities Sales

  • Current cash debt coverage ratio lets you know whether a company has enough cash to meet its short-term needs.

    Current cash debt coverage ratio = Cash provided by operating activities Average current liabilities

  • Cash flow coverage ratio finds out whether a company has enough money to cover its bills and finance growth.

    Cash flow coverage ratio = Cash flows from operating activities cash requirements