Read annual reports before investing

Annual reports: this is how you evaluate the balance sheet correctly

Annual reports give you a good look at company balance sheets. GeVestor shows you how to correctly analyze and evaluate the balance sheet.

At a glance: The most important components of an annual report

In this part, the management gives an account of the past financial year.

There is also a medium to long-term outlook on planned entrepreneurial action.

The balance sheet compares the origin and use of the money available to the company.

It shows how the company is doing economically.

  • Profit and Loss Account

The income statement (P&L) shows how well the company has done in the past financial year.

Profit is a decisive criterion, especially for short-term investors.

The cash flow or cash flow statement shows the cash flows in the company.

Here it becomes clear how successfully a company has operated its core business, how wisely it has invested and how it has handled the available money.

Example of a balance sheet (Adidas 2005)

Active sidePassive side
Short-term assets (up to 3 months)€ 4,367 millionShort term liabilities€ 1,790 million
Long-term active (over 3 months)€ 1,384 millionLong-term liabilities€ 1,248 million
Total equity€ 2,712 million
Total assets€ 5,750 millionTotal liabilities€ 5,750 million

example: At Adidas, the ratio is € 2,712 million / € 5,750 million, i.e. around 47.5% - a very healthy ratio.

In 2004 it was 35.2%. You should generally view all companies with skepticism where the equity ratio has been below 20% for several years.

You should also consider the coverage ratio when looking at your company. It states whether the Group's fixed assets (long-term assets) are covered by equity.

The odds are calculated using the simple formula Equity divided by fixed assets. If the ratio is greater than 1, this speaks for the company.

Example Adidas: Here the ratio is just under 2 (2,712 / 1,384 = 1.96), which is a very good value.

Another important key figure in balance sheet analysis is the degree of liquidity. For the calculation, put the liquid funds and the short-term investments in relation to the short-term borrowed capital.

Rule of thumb: If the result is greater than 1, the short-term debts are covered.

Example Adidas: The short-term assets amount to € 4,367 million, the short-term liabilities to € 1,790 million. The ratio is around 2.44 - an excellent value.

Profit or loss? That's how profitable the company works

The income statement (P&L) shows you how the company has managed its assets and how sales and profit have developed compared to the previous year.

Example of an income statement (Adidas)

The annual surplus is determined from sales in several intermediate steps:

  • Step 1: Calculating the gross result

Sales less cost of sales lead to gross or gross profit. If you put them in relation to the total revenues, the result is the gross margin or “gross margin”.

At Adidas it is 3,179 / 6,636 = 48.18% - a good value; which is due to the fact that Adidas does not need any expensive machines or preliminary products for production.

  • Step 2: Calculating the operating result

To calculate the operating result, subtract sales, advertising and administrative costs from this number.

These are the sums that cannot be directly assigned to individual products or services, but are largely independent of the number of articles produced.

  • Step 3: Calculating Profit Before Tax
  • The financial result, which is made up of interest expenses, for example for loans, and interest income for invested money, is deducted from the operating result. The result is the pre-tax profit.
  • Step 4: Calculating Income from Continuing Business

Now - arithmetically - the income taxes have to be paid. The result is usually the after-tax profit, also known as the annual surplus.

At Adidas, however, the sale of the Salomon division has resulted in a peculiarity. For this reason, the result from continuing operations must first be determined before the annual surplus can be calculated.

  • Step 5: Calculating the annual surplus

The profit from discontinued operations (Salomon division) is deducted from the result from continued operations. The result is the annual surplus.

How to evaluate the income statement correctly

Of course, the income statement also helps you to evaluate a company. In the following, the "investment advisor" shows you how you can calculate the most important key figures yourself using the P&L figures from Adidas:

It indicates the ratio of profit to sales. Simply divide the net income by the sales and you get the return on sales, which the higher it is, the more attractive it is.

In the example of Adidas, we come to a value of € 390 million in net income and € 6,636 million in sales, i.e. almost 5.9%. Anything over 5% is a relatively good value.

As a rule, only companies that have a very strong position in the market generate double-digit returns on sales.

The relation between net income and market value is interesting. This ratio is also known as Return on equity.

It should be well above the interest rate achievable on the money market - and ideally over a period of years.

In the example of Adidas, the ratio is a profit of € 390 million to 204,496,860 shares times € 37.75 (price on December 31, 2005), i.e. a market value of just under € 7,700 million.

The return on equity is thus around 5.1%, i.e. about twice the return that can currently be earned on the money market without risk - also a good value.

You put the annual profit in relation to the liabilities side of the balance sheet. In this way you get to the bottom of the question of what the company generates with the money available.

Here, too, a higher value is always more attractive than a lower one. The return on total investment is also called Return on investment designated.

  • Price / earnings ratio (P / E)

This key figure is particularly popular with investors, but is only of limited use as a benchmark, as it can only be used as a meaningful comparison within individual sectors.

Use the current price of the stock, not the year-end price found in annual reports.

"Investment advisor" tip: For comparison, use either competing companies or, even better, special industry indices such as “Prime Retail” for retail or the “Dow Jones Euro-Stoxx Technology” for high-tech companies.

Compare the P / E ratio of the respective company with the industry P / E ratio.

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