A BEGINNER'S GUIDE TO INVESTING IN SHARES: Lies, damned lies and annual reports

Much effort goes into presenting the accounts in the best possible light, writes Magnus Grimond
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The Independent Online
Accounts are a tedious but a necessary evil for the investor. Once you have grasped the basics, they can throw up useful storm warnings for the wary. Companies still have plenty of scope for "creative accounting", despite moves to tighten up the rules by accountancy's watchdog, the Accounting Standards Board, and its rottweiler-in-chief Sir David Tweedie.

Be warned, though: reading accounts can be hard work. The extensive and often turgid notes at the back are often where the meat is to be found. Insist on the full report and accounts and not the anaemic "annual reviews" full of glossy photographs, blurb and details of directors' pay so much in vogue.

Once you have had a quick look at the profit and loss account and balance sheet, check on how well they marry up with the cash flow. Are seemingly huge profits being translated into cash in the bank, or are they being lost in working capital? At Tarmac, the quarrying group, for instance, an underlying profits recovery has been accompanied in recent years by poor cash flow and a rise in borrowings.

Look at policies where management has wide discretion. Have provisions been set up to cover redundancies and write-offs at a business being reorganised? If so, they may be dribbled out over several years, smoothing profits and distorting the underlying trend.

The depreciation charge is another key area that can offer managements generous scope for massaging the profit and loss account. Rather than charging the full cost of major assets like plant and buildings against the profit and loss account, companies are allowed to set aside - or depreciate - a proportion over its expected useful life. Nothing wrong with that if the company takes a consistently tough line. But extend the forecast life of the assets a little, cutting the amount set aside each year, and out of the hat comes a handy one-off lift to profits with no effort at all.

With depreciation in mind, it is worth taking a look at just what a company's so-called assets actually represent. They can be, literally, intangible. This applies in spades to Grand Metropolitan, the drinks to hamburgers group that is teaming up with Guinness to form Diageo. More than its entire shareholders' funds is represented by "intangibles", in this case a range of household-name brands such as Smirnoff, Burger King and Haagen-Dazs, valued at a whopping pounds 3.84bn.

Grand Met is only able to value these brands so precisely because it has spent the last 12 years paying huge amounts of "goodwill" to acquire them. Goodwill is the difference between what the company paid and the value of the real, tangible assets. Most companies write goodwill off immediately. GrandMet's reluctance is explained in part by the fact that all its shareholders' funds of pounds 3.1bn and more would be wiped out if it followed that course. Even if the Accounting Standards Board is about to give its blessing to the company's approach, investors should make their own judgement. A tired brand with falling sales may not now be worth what a company paid for it.

Balance sheet assets are important because when the chips are down lenders usually have the right to grab them to pay off a company's borrowings or debt. If the loans are "secured" and the company has breached certain conditions, they also have the right to put in a receiver to run the company.

So look at the "gearing ratio" - simply, this is borrowings less cash divided by the net assets. Anything above about 75 per cent for most companies, and the alarm bells should start to ring.

Arguments about what assets are worth, and the frequent difficulty of realising their full value when it becomes necessary to pay off debt, have led bankers and others to favour "interest cover" over gearing to measure borrowings. This is simply the number of times that the interest bill is covered by profits. If it is down at two or three times, then, again, the investor should start ask some serious questions.

Don't just focus on the numbers. Take a close look also at the directors' report. The outlook or prospects section will often give valuable clues about how things are going. Beware statements like "we are well positioned for recovery", which implies that there is something serious to recover from. Watch out, too, for persistent over-optimism.

Albert Fisher, the food group, is a case in point. The shares have more than halved in value in four years as management has consistently disappointed the City by overestimating the extent of recovery. In its 1996 report Fisher seemed to suggest profits growth was at last coming through, while problems with the weather were a thing of the past. Yet by February this year it was forced to admit that the previous year's devastation by frost of its Dutch cockle beds would hit the results of the seafood division. Profits for the year to August turned out to be as flat as a pancake.

These few examples just scratch the surface of what the investor needs to look out for in accounts. Many highly paid people spend many hours attempting to present the accounts in the best possible light. Others are paid equally as much to dissect them, so look out for unbiased stockbrokers' research on companies you like and follow the financial press to see what is cooking. But at the end of the day, it is usually best to rely on your own judgement.

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