Outline and Content
The book is in four Parts.
Part 1 describes the logic of financial statements and introduces some of the main ideas.
Part 2 discusses balance sheet accounting and the accounting principles and rules, collectively known as Generally Accepted Accounting Principles or GAAP, that determine the content of the balance sheet and how the numbers are measured.
Part 3 explains how to measure and analyse the profitability and financial structure of a business using financial ratios.
Part 4 shows how to analyse income, cash flow and growth
Click below to see chapter summaries.
A balance sheet is a list in monetary terms of a company’s assets, and of its liabilities, which are the claims on those assets from outsiders. The difference between the assets and the liabilities measures the wealth or ‘equity’ of the owners of the company in balance sheet terms. The accounting income the company earns for its owners is simply the growth in the balance sheet equity, adjusted for any cash they have taken out or put in.
The balance sheet is the fundamental economic record and it lies at the heart of the economic judgements we make about a business. Later in this chapter, some measures of financial structure are described, that relate the claims on the business to the assets that are available to meet those claims, and the next chapter describes some measures of return on capital or profitability that compare the income to the assets used to earn that income.
The reliability of these measures depends critically on the data integrity of the balance sheet – on whether it provides a complete list of assets and liabilities, and on the monetary values they are carried at. These issues are discussed throughout the book, but the chapter lays out the ground.
An income statement is a structured narrative that explains how a company earned its income during the period. The accounting income a company earns for its owners is simply the change in its balance sheet equity, adjusted for any cash the owners have taken out or put in. In principle, you can see how much income a company has earned by looking at the balance sheet. In earlier times, that was probably enough – typically, ventures were quite simple and had a finite life, and the owners were close to the business (see the note, Some history).
Modern companies are likely to be complex and continuing entities with investors who have no day-to-day contact with the business. These investors need to judge whether the business will earn an adequate return on their investment, and they need to estimate the future stream of income, and the risks to that, so they can value the business. So they need to understand how the business earns its income. That is the role of the income statement.
The income statement reports the sales during the period, and the different types of cost that were incurred. Each tranche of cost relates to a measure of income. So if we are going to use income statement data we need to understand the nature of the sales number and the nature of the costs that GAAP accounting gives us. We take a first look at these issues in this chapter. We also describe the measures of profit margin that are used to describe the company’s economic model and to judge its efficiency in operation, and the common measures of return on investment that compare the income of the business to capital employed to earn that income.
As with the balance sheet, the income statement model is remarkably effective in describing the great variety of business and business model in a way that makes them comparable in economic terms. The main problem is disclosure – the devil can be in the lack of detail. We usually want more information from companies about the nature and behaviour of their revenues and costs than we actually get.
The cash flow statement is the third of the core financial statements. To understand how the cash flow statement relates to the balance sheet and income statement it helps to go back to the basics of accounting, so the chapter starts by explaining the accounting process.
The balance sheet is the fundamental accounting record. It records the assets and liabilities of the business; the difference between these is the wealth of the owners in balance sheet terms. The accounting process, the bookkeeping, is best understood as a spreadsheet that updates the balance sheet each time there is a transaction. At the end of the period, the financial statements are read straight off the spreadsheet. The final row of data on assets and claims forms the ending balance sheet. To explain the performance of the period, that is, how the business got to the ending balance sheet from the starting balance sheet, the accountant prepares a cash flow statement from the flows of cash in the cash column, and an income statement from the flows of revenue and expense in the profit column.
Cash flow, profit, and the balance sheet are bound together by a logical identity – if you know two, you can deduce the third. Paradoxically, that is why all three statements are so useful. The cash flow statement, in particular, triangulates and challenges the insights about financial structure and profitability from the balance sheet and income statement.
An accounting model is a set of rules or logic that determines what assets and liabilities go into the balance sheet and at what values. The accounting model determines income, period by period, because the accounting income of the owners of a business is the change in their equity in the balance sheet, allowing for any cash they have taken out or put in. The accounting model that is used for company accounting is called ‘accrual accounting’, where the balance sheet records the assets a company owns, and records the claims that outsiders have against the company.
For financial statements to yield reliable and timely measures of profit and of financial structure would require a rather demanding version of accrual accounting in which the balance sheet to provides a complete record of the assets and liabilities of the company and measure them at their current values. This provides the touchstone throughout this book. But this is not what GAAP does. GAAP’s version has a strong bias to ‘conservatism’ and has a preference to recognise bad news early. It tries to be complete in liabilities, but it tends to understate assets. The general effect is to understate equity and to postpone income.
A core idea in this chapter, indeed throughout the book, is that the way the balance sheet is drawn up determines income. GAAP also sees the balance sheet as the primary financial statement. But this is not how most companies and accountants view the world. For them income measurement is the starting point and the balance sheet is a sideshow, perhaps a constraint. The chapter discusses this fundamental tension in accounting.
The chapter ends by comparing accrual accounting to two alternative accounting models that are sometimes proposed and occasionally creep in to GAAP. These are ‘economic value accounting’ and ‘cash accounting’. An important insight is that over the whole life of a business it does not matter how the accounting is done. But, period-by-period, the income a company reports is entirely dependent on the accounting model.
A company or corporation is a business that has a separate legal personality from its owners as a result of being ‘incorporated’. This chapter explains the idea of a company and discusses some of the accounting issues that incorporation leads to.
One consequence of incorporation is limited liability which means that, if the business fails, its creditors have a claim against the assets of the company but not against the personal assets of the owners. Another consequence is that the managers and the owners of the company may now be separate people so there is a separation of ownership and control.
Limited liability and the separation of ownership and control bring potential conflicts of interest between stakeholders. It was the need to protect creditors from owners, and to protect owners from managers, that led to the requirement to publish financial statements and led to the evolution of GAAP. The chapter assesses how GAAP is evolving and whether GAAP is converging to one international set of rules.
This chapter explains what GAAP requires for an asset to be carried or ‘recognised’ in the balance sheet, and it explains how the cost of the asset is measured. Asset accounting involves three key pieces of vocabulary. If GAAP allows an asset to be carried in the balance sheet, we say that the company can recognise the asset. This means that it can capitalise the costs that were incurred to build or acquire the asset. Costs that cannot be capitalised have to be expensed, that is, charged to profit in the year.
For an accountant, an asset and an expense are the same thing (they are both ‘debits’ in accounting language). An asset is just an expense that has not been used yet and that is stored in the balance sheet to be used in some future period. So accountants do not sit in front of a blank piece of paper, chewing a pencil and wondering ‘what assets have we got?’ The balance sheet recognition of assets is simply a binary choice between expensing and capitalising the costs the business has actually incurred.
In everyday language an asset is anything that may yield benefit in the future. But GAAP’s notion of an asset is more restrictive than this. The problem GAAP faces is that a balance sheet is black and white, while the value and even the existence of assets depends on future events and is uncertain. GAAP deals with the uncertainty of the world by setting thresholds for asset recognition, applied with a strong bias to conservatism. This turns out to be tough on home-grown intangible assets, which typically do not meet GAAP’s recognition tests. But if a company buys an asset in an external transaction, such as the purchase of another company, it is recorded in the balance sheet at its cost, whether the asset is tangible or intangible.
The main operating assets of a business are tangible and intangible fixed assets, and inventory. This chapter examines how these assets are measured in the balance sheet.
Assets are initially recorded in the balance sheet at what they cost. The question is what happens after that. GAAP conservatism means there is a sharp difference in treatment depending on whether the asset’s value has gone up or down. If values go down, the loss of value is recognised right away. If the asset’s value goes up, the increase in value is unlikely to be recognised until it is realised by the asset being sold.
US GAAP does not allow the upward revaluation of long-term assets and under IFRS, though this is an option, it is not usually done. As a result, balance sheets contain a cocktail of valuations of different vintages, with a general tendency to undervalue operating assets and thus to understate equity. Users need to be aware of this when interpreting measures of profitability and capital structure.
The chapter starts with a discussion of the sometimes confusing asset valuation vocabulary and examines what a balance sheet that measured current values would theoretically require. It then outlines GAAP’s measurement rules for operating assets, with a particular focus on impairment, which is the centrepiece of GAAP’s conservative approach to valuation.
The chapter ends by explaining why measuring operating assets at current values is often infeasible, and it examines the impact of the resulting historical-cost bias in balance sheets. The bias depends on the nature of the business and the extent to which it is using old physical assets – the chapter demonstrates this using a case study from brewing and pubs, which is a particularly real-estate-intensive industry.
A later chapter looks at the measurement of financial assets and liabilities. There, GAAP takes a slightly different approach and requires some financial assets and liabilities to be revalued up or down annually to current value or so-called ‘fair value’.
This chapter explains what liabilities are recognised in the balance sheet, and how they are measured. We want a company’s balance sheet to record all of its liabilities. Liabilities such as borrowings, trade payables, current tax due, are all determinate in that their existence and their size is known, so not much needs to be said about these liabilities. A glance at the balance sheets reviewed in Chapter 1 shows that many or most liabilities are of this sort.
The challenge comes with liabilities that are contingent on uncertain future events, so that at the date of the balance sheet it is unclear how big the liability is and even whether it exists at all. This indeterminacy cannot easily be represented in the black and white world of accounting. In this case, the company has to estimate the liability and accountants use the word provision or reserve for an estimated liability.
GAAP requires the main operating liabilities of a company, such as deferred tax liabilities, pension deficits, and asset retirement obligations, to be remeasured to current value in the balance sheet each year. The chapter examines pensions in some detail, as an example of a liability that can be very large and challenging to estimate, with consequences for income measurement.
This chapter is about ‘pure liability recognition’. Holding the assets constant, if a company recognises a liability that it had not recognised before this must reduce equity. Another set of accounting issues arises when liabilities are linked to assets so that the asset and liability are recognised, or derecognised, together. That is the subject of the next chapter.
This chapter examines how financial assets and liabilities are measured in balance sheets. For measurement purposes, assets are either ‘operating’ or ‘financial’ in GAAP. The principal operating assets are inventory, and tangible and intangible long-term assets. The main financial assets of a business are: Cash; Loans and receivables, that is, promises to pay by a third party, or contractual rights to receive cash or another financial asset from a third party; Equity instruments issued by other entities.
All companies have financial assets such as cash and receivables, and many industrial and commercial companies use financial derivatives. But bank balance sheets are dominated by financial assets and liabilities. So this chapter is also the natural place to introduce the balance sheets of banks, and contrast them with those of the industrial and commercial companies. It does this using Standard Chartered as an example.
A striking feature of bank balance sheets is their relative lack of equity capital and one consequence of this is the need for close regulation of banks. Later, the chapter describes the gearing ratios that bank regulators use to measure and regulate the capital adequacy of banks. Another consequence of thin equity is that quite small changes in the valuation of financial assets and liabilities can have a significant impact on equity and so on the measured capital adequacy of banks.
The first task of financial analysis is to measure how profitable a business is by measuring the return the company earns on the capital provided by its investors. This chapter explains how the commonly-used accounting measures of return on capital are calculated.
The question is whether to measure return at the equity level or the entity level. Return on Equity, that was introduced earlier in the book, is a simple and universally-used measure and there is no need to say much more about it here. Most of this chapter is devoted to measuring entity-level return.
The entity-level measure, Return on Capital Employed, comes in a number of forms and has various names, and it can be challenging to define in practice. When the objective is to compare the entity return to the investors’ required return, that is, to the cost of capital, the return needs to be measured after tax. This, in turn, leads to the important concept of Economic Profit, commonly known as Economic Value Added.
Having measured return on capital, the next step is to understand why it is what it is. This chapter explains how to conduct a forensic analysis of profitability. The approach is to decompose ROCE using the data the company discloses about the components of costs and of profit, and about assets and liabilities. The analyst also uses any non-financial performance data the company provides.
The key first step in analysing operating performance is to split ROCE into its ‘margin’ and ‘asset turn’ components to reveal the company’s ‘profitability equation’. Data permitting, the same analysis of the profitability equation can then be done for each distinct business segment in the company; that is, the company is decomposed vertically into its segments.
In a perfectly competitive world all companies would earn the same return on capital, but even in that case the shape of the profitability equation that lies behind the company’s return on capital will depend on the technology of the business it is in. Businesses that need relatively more tangible assets, that are more ‘capital-intensive’, will have to earn a higher margin to pay for them.
But the shape of the profitability equation also depends on the business model the company chooses. There will often be different ways to achieve the same business goal, involving different patterns of ownership of assets, that give a very different look in terms of margin and asset turn. In many industries, there are now strenuous efforts towards an ‘asset light’ balance sheet as a way of delivering return on capital.
The previous chapter showed how to identify the drivers of return on capital by analysing the profitability equation. It emphasised the impact of the business model that a company uses, and of the increasingly common asset-light balance sheet. GAAP’s treatment of intangible assets also has a significant effect on measured return on capital and on the profitability equation. This chapter examines that impact and, in doing so, revisits the question of whether intangibles should be recognised in the balance sheet.
Intangibles like brands, patents, organisational competencies and knowhow may be the most valuable assets a company has, but GAAP conservatism generally requires the costs of creating them to be expensed as they are incurred. By contrast, if the intangible asset was purchased in a transaction such as an acquisition of another company, it is recognised in the balance sheet. So the balance sheets of companies that grow organically are less complete than those that grow by acquisition and, in consequence, their equity is understated.
A few analysts, and some data providers, routinely capitalise R&D expenditure to correct this GAAP bias, and the chapter explores the mechanics and the challenges of doing this. Nonetheless, most intangible ‘capex’ is now expensed through the income statement, raising real challenges in interpreting profitability.
This chapter explains how to measure and analyse a company’s financial structure, and examines the implications of financial structure for risk and return.
Companies need assets in order to operate, but operations also generate liabilities so it is the net operating assets that determine the amount of capital that the company must raise from investors, either as equity or debt. The tax system provides a strong incentive to use debt capital. Moreover, using debt lets the owners raise additional finance without having to share control and the other benefits of ownership. But the use of debt finance brings fixed cost to the income statement, in the form of a commitment to pay interest. This ‘financial leverage’ or ‘gearing’ adds volatility to earnings, and increases the risk that in some states of the world the company will fail.
The chapter starts by describing the commonly used measures of financial structure. This is also the natural place to explain how the weighted average cost of capital (WACC) is calculated. The chapter then examines how EBIT is shared between interest, tax and earnings, and how leverage affects the level and the volatility of earnings and of return on capital. Fixed operating costs have the same effect as interest costs, and the proportion of operating costs that are fixed is known as ‘operating leverage’. In most companies, fixed operating costs exceed financing costs so that operating leverage is usually the more influential of the two leverages.
The chapter ends by discussing extreme leverage. Some companies pursue a strategy of extreme financial leverage involving high borrowing while correspondingly stripping the equity out of the business. The chapter shows how this works.
Tax, along with labour, is the largest single expense for many companies. But a company’s tax position is complex and, for the outsider, is notoriously hard to understand. The interaction of the tax system with GAAP accounting means that this year’s activities can have tax effects long into the future, requiring significant tax liabilities and tax assets to be recognised in the balance sheet.
The tax authorities also use accrual accounting to measure taxable profit, but in key areas they use a different accrual accounting model to GAAP’s model. GAAP reconciles the two using ‘deferred tax accounting’. In principle that should render tax purely proportionate to profit before tax each period. That is not what we get. In practice, GAAP’s tax accounting adds significant volatility to earnings.
This chapter explains how tax affects the financial statements. The best strategy for the reader of the financial statements is to get as good an appreciation as possible of the drivers of a company’s effective tax rate from its financial statements, then to require the company to provide guidance on how its future tax rate will evolve. In practice, the ability and willingness of companies to provide this guidance is very mixed. So tax is problematic, and requires more attention than it usually receives, which is why it is given additional attention here.
People read financial statements with different motives. Usually, they are intending to deal with the business in some way – as equity or debt investors, as employees, as customers or suppliers, as regulators and economic planners – as ‘stakeholders’, in the fashionable phrase. Or maybe they have no contractual relationship with the business but are affected by its behaviour. Since the future is the only thing they can affect by their actions, their need is to understand the economics of a business in order to shape their expectations of the future. Implicitly, or explicitly, they need to build a financial model to forecast the free cash flow of the company.
A full treatment of financial modelling is out of scope for this book, but this chapter provides the structure. It starts by outlining the logic of a financial model and of the drivers of free cash flow, and it derives some rules of thumb for valuation. The main focus of the chapter is how to craft the ‘value narrative’, which is the economic rationale behind the numbers; a credible story about what will happen to free cash flow in the future.
The chapter ends by examining two factors that many people believe now lie at the heart of a company’s value narrative. One is the possession of valuable intangibles, the second is demonstrating purpose and managing the company to an agenda that focuses on environmental, social and governance (ESG) goals. These are not rivals to profit and cash flow, just, people argue, better predictors of them.