Understanding Business Accounting For Dummies, 2nd Edition (105 page)

The best known of these forms is the annual 10-K, which includes the business's annual financial statements in prescribed formats, with all the supporting schedules and detailed disclosures that the SEC requires.

Here are some (but not all) of the main financial reporting requirements that publicly-owned businesses must adhere to. (Private businesses may include these items as well if they want, but they generally don't.)

Management discussion and analysis (MD&A) section:
Presents the top managers' interpretation and analysis of a business's profit performance and other important financial developments over the year.

Earnings per share (EPS):
The only ratio that a public business is
required
to report, although most public businesses do report a few other ratios as well. See ‘Earnings per share, basic and diluted' later in this chapter. Note that private businesses' reports generally don't include any ratios (but you can, of course, compute the ratios yourself).

Three-year comparative profit and loss account:
See Chapter 5 for more information about profit and loss accounts.

Note:
A publicly-owned business can make the required filings with the Stock Exchange or SEC and then prepare a different annual financial report for its shareholders, thus preparing two sets of financial reports. This is common practice. However, the financial information in the two documents can't differ in any material way. A typical annual financial report to shareholders is a glossy booklet with excellent art and graphic design, including high-quality photographs. The company's products are promoted and its people are featured in glowing terms that describe teamwork, creativity, and innovation - we're sure you get the picture. In contrast, the reports to the London Stock Exchange or SEC look like legal briefs - nothing fancy in these filings. The core of financial statements and footnotes (plus certain other information) is the same in both the Stock Exchange filings and the annual reports to shareholders. The Stock Exchange filings contain more information about certain expenses and require much more disclosure about the history of the business, its main markets and competitors, its principal officers, any major changes on the horizon, and so on. Professional investors and investment managers read the Stock Exchange filings.

Most public companies solicit their shareholders' votes in the annual election of persons to the board of directors (whom the business has nominated) and on other matters that must be put to a vote at the annual shareholders' meeting. The method of communication for doing so is called a
proxy statement
- the reason being that the shareholders give their votes to a
proxy
, or designated person, who actually casts the votes at the annual meeting. The Stock Exchange requires many disclosures in proxy statements that are not found in annual financial reports issued to shareholders or in the business's annual accounts filed at Companies House. For example, compensation paid to the top-level officers of the business must be disclosed, as well as their shareholdings. If you own shares in a public company, take the time to read through all the financial statements you receive through the post and any others you can get your hands on.

Analysing Financial Reports with Ratios

Financial reports have lots of numbers in them. (Duh!) The significance of many of these numbers is not clear unless they are compared with other numbers in the financial statements to determine the relative size of one number to another number. One very useful way of interpreting financial reports is to compute
ratios
- that is, to divide a particular number in the financial report by another. Financial report ratios are also useful because they enable you to compare a business's current performance with its past performance or with another business's performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In other words, using ratios cancels out size differences.

The following sections explain the ten financial statement ratios that you're most likely to run into. Here's a general overview of why these ratios are important:

Gross margin ratio and profit ratio:
You use these ratios to measure a business's profit performance with respect to its sales revenue. Sales revenue is the starting point for making profit; these ratios measure the percentage of total sales revenue that is left over as profit.

Earnings per share (EPS), price/earnings (P/E) ratio, and dividend yield:
These three ratios revolve around the market price of shares, and anyone who invests in publicly-owned businesses should be intimately familiar with them. As an investor, your main concern is the return you receive on your invested capital. Return on capital consists of two elements:

• Periodic
cash dividends
distributed by the business

• Increase (or decrease) in the
market price
of the shares

Dividends and market prices depend on earnings - and there you have the relationship among these three ratios and why they're so important to you, the investor. Major newspapers report P/E ratios and dividend yields in their stock market activity tables; stockbrokers' investment reports focus mainly on forecasts of EPS and dividend yield.