Understanding Business Accounting For Dummies, 2nd Edition (130 page)

Marketable securities
is the asset account used for investments in shares and bonds (as well as other kinds of investments). Companies that have more cash than they need for their immediate operating purposes put the excess funds to work earning investment income rather than let the money lie dormant in a bank checking account. The accounting rules for marketable securities are fairly tight; you needn't be concerned about this asset.

If you encounter an asset or liability you're not familiar with, look in the footnotes to the financial statements, which present a brief explanation of what the accounts are and whether they affect profit accounting. (We know, you don't like reading footnotes; neither do we.) For example, many businesses have large liabilities for unfunded pension plan obligations for work done in the past by their employees. The liability reveals that the business has recorded this component of labour expense in determining its profit over the years. The liability could be a heavy demand on the future cash flow of the business.

How Well Are Assets Being Utilised?

The overall test of how well assets are being used is the
asset turnover ratio
, which equals annual sales revenue divided by total assets. (You have to calculate this ratio; most businesses do not report this ratio in their financial statements, although a minority do.) This ratio tests the efficiency of using assets to make sales. Some businesses have low asset turnover ratios, less than 2-to-1. Some have very high ratios, such as 5-to-1. Each industry and retail sector in the economy has a standard asset turnover ratio, but these differ quite a bit from industry to industry and from sector to sector. There is no standard asset turnover ratio for all businesses. A supermarket chain couldn't make it if its annual sales revenues were only twice its assets. Capital-intensive heavy manufacturers, on the other hand, would be delighted with a 2-to-1 asset turnover ratio.

Financial report readers are wise to track a company's asset turnover ratio from year to year. If this ratio slips, the company is getting less sales revenue for each pound of assets. If the company's profit ratio remains the same, it gets less profit out of each pound of assets, which is not good news for equity investors in the business.

What Is the Return on Capital Investment?

We need a practical example to illustrate the
return on capital investment
questions you should ask. Suppose a business has £12 million total assets, and its creditors and accrued liabilities for unpaid expenses are £2 million. Thus, its
net operating assets
- total assets less its non-interest-bearing operating liabilities - are £10 million. We won't tell you the company's sales revenue for the year just ended. But we will tell you that its earnings before interest and tax (EBIT) were £1.32 million for the year. The basic question you should ask is this: How is the business doing in relation to the total capital used to make this profit?

EBIT is divided by assets (net operating assets, in our way of thinking) to get the
return on assets
(ROA)
ratio. In this case, the company earned 13.2 per cent ROA for the year just ended:

£1,320,000 EBIT ÷ £10,000,000 net operating assets = 13.2% ROA

Was this rate high enough to cover the interest rate on its debt? Sure; it's doubtful that the business had to pay a 13.2 per cent interest rate. Now for the bottom-line question: How did the business do for its
owners
, who have a lot of capital invested in the business?

The business uses £4 million total debt, on which it pays 8 per cent annual interest. Thus, its total owners' equity is £6 million. The business is organised as a company that pays 30 per cent tax on its taxable income.

Given the company's capitalisation structure, its EBIT (or profit from operations) for the year just ended was divided three ways:

£320,000 interest on debt:
£4,000,000 debt × 8 per cent interest rate = £320,000

£300,000 income tax:
£1,320,000 EBIT - £320,000 interest = £1,000,000 taxable income × 30 per cent tax rate = £300,000 income tax

£700,000 net income:
£1,320,000 operating earnings - £320,000 interest - £300,000 income tax = £700,000 net income

Net income is divided by owners' equity to calculate the
return on equity
(ROE)
ratio, which in this example is

£700,000 net income ÷ £6,000,000 owners' equity = 12% ROE

Some businesses report their ROE ratios, but many don't - generally accepted accounting principles don't require the disclosure of ROE. In any case, as an investor in the business, would you be satisfied with a 12 per cent return on your money?

You made only 4 per cent more than the debt holders, which may not seem much of a premium for the additional risks you take on as an equity investor in the business. But you may predict that the business has a bright future and over time your investment will increase two or three times in value. In any case, ROE is a good point of reference - although this one ratio doesn't give you a final answer regarding what to do with your capital. Reading Tony Levene's
Investing For Dummies
(Wiley) can help you make a wise decision.

What Does the Auditor Say?

A business pays a lot of money for its audit, and you should read what the auditor has to say. We'll be frank: The wording of the auditor's report is tough going. Talk about jargon! In any case, focus on the sentence that states the auditor's
opinion
on the financial statements. In rough terms, the auditor gives the financial statements a green light, a yellow light, or a red light - green meaning that everything's OK (as far as can be ascertained by the process of the audit), yellow meaning that you should be aware of something that prevents the auditor from giving a green light, and red meaning that the financial statements are seriously deficient.

Look for the key words
true and fair
.
These code words mean that the audit firm has no serious disagreement with how the business prepared its financial statements. This unqualified opinion is called a
clean opinion
. Only in the most desperate situations does the auditor give an adverse opinion, which in essence says that the financial statements are misleading. If the audit firm can't give a clean opinion on the financial statements or thinks that something about the financial statements should be emphasised, a fourth paragraph is added to the standard three-paragraph format of the audit report (or additional language is added to the one-paragraph audit report used by the big accountancy firm PricewaterhouseCoopers). The additional language is the tip-off; look for a fourth paragraph (or additional language), and be sure to read it. The auditor may express doubt about the business being able to continue as a going concern. The solvency ratios discussed earlier should have tipped you off. When the auditor mentions it, things are pretty serious.