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About the author Accounts Demystified how to understand financial accounting and analysis “An excellent primer on accounting, this book explains in simple language how to understand balance sheets, profit and loss accounts and cash flow statements. It also has useful chapters covering important subjects like return on capital employed, gearing and book values as well as providing insight into the tricks of the accounting trade.” Jim Slater, investment guru and best selling author of The Zulu Principle Accounts Demystified Anthony Rice is not an accountant. He learned his accounting the hard way – by keeping the accounts for his own company. It wasn’t until the fifth consecutive weekend in the office struggling with the accounting system that he realised, quite suddenly, how simple it all is. From that day, accounting lost its mystery. Over the next couple of years, he also found that, by focusing on the balance sheet and using diagrams, he could quickly demystify fellow sufferers. Having subsequently spent much of his time analysing companies, first as a strategy consultant and more recently when looking for businesses to buy, he has some valuable insights into financial analysis. He now divides his time between his businesses and demystifying other subjects that ‘just can’t be as hard as they seem’. His next book, Statistics Demystified, is available from Prentice Hall Business in spring 2003. BOOKS THAT MAKE YOU BETTER “You won’t find a better explanation of the fundamentals of accounting and financial analysis than this. Trust me – no other book makes the subject as simple and clear.” Jamie Reeve, Lynx Capital Ventures “Explains what many people find a complicated subject in very clear and simple terms. I will be recommending this book to all our new trainees.” Jonathan Munday, Partner, Rees Pollock Accountants Anthony Rice Accounting is generally viewed as a highly technical and complex subject. In truth, it is actually based on an incredibly simple principle that is hundreds of years old. Once you understand this principle and how it is applied, you will find accounting and financial analysis easy. In this straightforward, easy to read book, the author guides you with extraordinary clarity through this principle and onto all the major accounting concepts. Using simple diagrams and everyday analogies, this book will help you really understand: • balance sheets, profit and loss accounts and cash flow statements • how they all work together • the meaning of all the major features of annual reports • how to analyse a company’s financial performance • why return on capital employed is the measure that matters • how creative accountants cook the books and how to spot it. Accounts Demystified is the definitive, user-friendly guide to the fundamental principles of accounting that no novice user of accounts can do without. £14.99 –––––––––––––––––– BUSINESS –––––––––––––––––– ISBN 0-273-66334-8 Visit us on the web www.business-minds.com www.yourmomentum.com Cover photograph © Stone 2003 9 780273 663348 Prentice Hall Business is an imprint of Pearson Education Prentice Hall Prentice Hall BUSINESS BUSINESS Whether you are a manager on the way up, a trainee accountant, an entrepreneur, a student or an investor – this book is for you. In fact, it is for anybody who wants to be able to look at a balance sheet, profit and loss account or cash flow statement and understand, digest and talk about the numbers with confidence. In this 4th edition of the classic Accounts Demystified, Anthony Rice makes accounting astonishingly simple and pain-free. Accounts Demystified Prentice Hall BUSINESS Books to make you better Books to make you better. To make you be better, do better, feel better. Whether you want to upgrade your personal skills or change your job, whether you want to improve your managerial style, become a more powerful communicator, or be stimulated and inspired as you work. Prentice Hall Business is leading the field with a new breed of skills, careers and development books. Books that are a cut above the mainstream – in topic, content and delivery – with an edge and verve that will make you better, with less effort. Books that are as sharp and smart as you are. Prentice Hall Business. We work harder – so you don’t have to. For more details on products, and to contact us, visit www.business-minds.com www.yourmomentum.com Pearson Education ANTHONY RICE Accounts Demystified How to understand financial accounting and analysis an imprint of Pearson Education London • New York • Toronto • Sydney • Tokyo • Singapore • Hong Kong • Cape Town New Delhi • Madrid • Paris • Amsterdam • Munich • Milan • Stockholm PEARSON EDUCATION LIMITED Head Office: Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 London Office: 128 Long Acre London WC2E 9AN Tel: +44 (0)20 7447 2000 Fax: +44 (0)20 7447 2170 Website: www.business-minds.com ____________________________ First published in Great Britain in 1993 © Anthony Rice 2003 The right of Anthony Rice to be identified as Author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 66334 8 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. 10 9 8 7 6 5 4 3 2 1 Typeset by Northern Phototypesetting Co. Ltd, Bolton Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow The Publishers’ policy is to use paper manufactured from sustainable forests. Contents Preface ix Acknowledgements xi Prologue xiii Introduction xv Part I: The basics of accounting 1 The balance sheet and the fundamental principle 3 ● Assets, liabilities and balance sheets 3 ● Sarah’s ‘personal’ balance sheet 4 ● The balance sheet of a company 7 ● The balance sheet chart 11 ● Summary 14 2 Creating a balance sheet 17 ● Procedure for creating a balance sheet 17 ● SBL’s balance sheet 18 ● The different forms of balance sheet 48 ● Basic concepts of accounting 50 ● Summary 53 3 The profit & loss account and cash flow statement 55 ● The profit & loss account 55 ● The cash flow statement 57 ● ‘Definitive’ vs ‘descriptive’ statements 59 ● Summary 61 v CONTENTS 4 Creating the profit & loss account and cash flow statement 63 ● Creating the profit & loss account 63 ● Creating the cash flow statement 67 ● Summary 78 5 Book-keeping jargon 81 ● Basic terminology 81 ● The debt and credit convention 84 Part II: Interpretation of accounts 6 Wingate’s annual report 95 ● Accounting rules 96 ● The reports 97 ● Assets 99 ● Liabilities 107 ● Shareholders’ equity 114 ● The P&L and cash flow statement 115 ● The notes to the accounts 118 ● Summary 119 7 Further features of company accounts vi ● Investments 122 ● Associates and subsidiaries 124 ● Accounting for associates 125 ● Accounting for subsidiaries 127 ● Funding 128 ● Debt 129 ● Equity 131 ● Revaluation reserves 134 ● Statement of recognised gains and losses 135 ● Note of historical cost profits and losses 135 121 CONTENTS ● Intangible fixed assets 137 ● Leases 137 ● Corporation tax 140 ● Exchange gains and losses 141 ● Fully diluted earnings per share 143 ● Summary 146 Part III: Analysing company accounts 8 Financial analysis – introduction 149 ● The ultimate goal 150 ● The two components of a company 153 ● The general approach to financial analysis 162 ● Wingate’s highlights 163 ● Summary 166 9 Analysis of the enterprise 169 ● Return on capital employed (ROCE) 169 ● The components of ROCE 173 ● Where do we go from here? 177 ● Expense ratios 177 ● Capital ratios 184 ● Summary 192 10 Analysis of the funding structure ● The funding structure ratios 195 ● Lenders’ perspective 199 ● Gearing 201 ● Shareholders’ perspective 205 ● Liquidity 211 ● Summary 215 195 vii CONTENTS 11 Valuation of companies ● Book value vs market value 217 ● Valuation techniques 220 ● Summary 225 12 Tricks of the trade ● Self-serving presentation 228 ● Creative accounting 230 ● Why bother? 249 ● Summary 252 Glossary 253 Appendix 275 Index 286 viii 227 217 Preface A glance at the accounts of most of Britain’s larger companies could lead you to conclude that accounting is a very complex and technical subject. While it can be both of these things, accounting is actually based on an incredibly simple principle which was devised more than 500 years ago and has remained unchanged ever since. The apparent complexity of many companies’ accounts results from the rules and terminology that have developed around this fundamental principle to accommodate modern business practices. I believe that, once you really understand the fundamental principle and how it is applied, you will find that the rules and terminology follow logically and easily. This view determines the arrangement of the chapters in Accounts Demystified and it is important, therefore, to read them chronologically. You may, however, omit Chapter Five, which discusses book-keeping jargon and Chapter Seven, which concentrates on more sophisticated areas of accounting, without losing the thread of the book. May I also suggest that, before you reach Chapter Six, you photocopy the key parts of Wingate Foods’ accounts (pages 278 to 285). From Chapter Six onwards, the text refers to these pages frequently and you will find it much easier with copies in front of you. If you have any comments on the book, you are welcome to email me at ar@demystifyme.com Anthony Rice ix