Understanding and reading company accounts

Stevio, my moment of shame, I failed two exams in my MBA (well close to failed), one was "Production Control" which worried my employer at the time as I was head of "Production Control" (turned out I knew more than the examiner {gulp}), and Finance where again my interest in ABC (an alternative form of costing to that used in much of the Anglo-Saxon world) and an interest in Terry Smith's teachings meant that I only just touch base with trad. "accounting".  So I'm probably not the best person to talk to.

However I would recommend "Accounting for Growth" by T Smith (I assume ebay may have a copy) if you want to know the basic ways to "falsify" accounts.

Other than that maybe others could offer something

A very good question stevio , but not one that I can really shed much light on.  My background is engineering/IT/operational management consultancy not finance, and the limited amount I have learnt about SME accounts has realy come from having to prepare accounts for my own limited company (a noddy service company for freelance contracts with big companies that only trade with incorprated businesses).

A sensible financial analysis of a company really requires sight of the P&L statement as well as the balance sheet, and small companies are not obliged to file a P&L statement. Wth most small companies now using software to file accounts at CH, its becoming a rarity to see a P&L.   And stating the obvious, accounts are filed so far after the year end date, the information is out dated by the time it hits CH.

Tip:  Accounts are due at CH 9 months after the year end. The credit rating agencies start to decrease the credit score slightly at around 6 months, which then takes a more significant hit at 8 months and of course at 9 months if there are no filed accounts.   To maintain a decent credit rating accounts should be filed within 8 months of the year end (which is important for seeking additional sources of finance, credit terms for building supplies/architect fees etc).

My gut feel though is that for most p2p loans that are predominately asset secured (as opposed to balance sheet strength secured) accounts are of limited value. We are usually dealing with SPV's, and in many cases the interesting financial story is elsewhere in the group (the cash in from the p2p platform goes straight back out as an intercompany loan or a director loan). By contrast as an example, on the FS Bradford-on-Avon Flats loan the accounts (via the CH link I've posted on DDC) it is possible to see the fixed asset value of the property, and a loan into the company by the director (as well as the finance house loans which include FS) without being an expert in reading accounts.  That suggests to me a clean financial approach with everything associated with the project passing through the borrowing company's books.


EDIT 1:

The fixed asset value of the property in the FS Bradford-on-Avon Flats loan I referred to is valued on a WIP basis, and makes sense in the context of a journey from the last known sale price of the property to the expected GDV.  Twelve months ago on an AC Private board thread  (only accesible for those with AC Private board permissions) I discussed my analysis of the accounts of the borrowing company behind AC loans #182/#405.  In that case the asset value is vastly overstated compared to current VR's, the huge value of creditors/debtors was hard to fathom, and importantly it was impossible to reconcile the known interest charges being paid to AC with movements in shareholder funds.

EDIT 2:

I've just looked at the accounts for the FS Rishton Land borrower (loan in effective "default") which were filed at CH 2 days ago. They are dormant company accounts showing just the issued share capital, and so do not reflect the £1m loan from FS received 6 months before the year end.   Intuitively the Feb 2016 loan and asset value should be shown on the balance sheet for y/e Nov 2016 .... but not being an accountant there may be reasons why this is acceptable that I'm not aware of  (link to accounts via CH is in DD Central).

Now pause for a moment and reflect on what has happened to the £1m from FS. Its not as if the borrower's director has (m)any other companies (at least UK registered companies).

It rather depends on the type of loan; asset based property often uses SPV's, so other than group cross guarantees etc accounts are generally meaningless but other asset backed types such as pawn or cars accounts can give an insight as to the health of the sector/company but if we just look at SME (often unsecured or just PG) it will depend on the type of business; for example accountants, lawyers & the like often have fabulously profitable accounts, with mountains of intangible assets, like goodwill but often exclusively depend on "human capital" which if it walks, gets struck off or proves to be less than honest the loan may prove worthless which means "avoid lawyers" is not a bad investment principle.

For genuine SME's that make or contribute something to the real economy the main aspects I look for are simple profitability (can they do what they do already at a profit?), levels of existing debt & interest coverage (can they afford to take on & service the new debt?) what trends do they show in turnover, profits, net assets, debt, cashflow etc (is the firm healthy & improving?). Of course all this is just a snap shot & forms ONLY PART of any assessment, why do they want the loan? Do I trust the firm/main players & their ability or track record? What is the risk/reward balance & how does it compare to what else is available?

Some on this forum like nothing better than a couple of hours DD on CH or reading accounts, I am not one of them but I can interpret & understand the headlines & take them into account when making my own investment decisions but also find the more technical contributors on this platform a vital addition to my own DD & thank them for their continued contributions.

I did a couple of accounting modules eons ago as part of my degree course and have a rough and ready understanding of the basics, but wouldn't class myself as anything other than the most amateur of armchair amateur accountants .

That clear I'd echo a lot of what Butch Cassidy has said. Assuming that we're talking about SME lending (for which I think looking at accounts is most applicable) the first thing I do when I look at a loan proposition is think about the "story". Does it make sense? If I was in that business would I consider similar borrowing for a project like this? With that as context I consider the accounts.

When looking at the P&L:-

1. Is the company profitable? If not it's a red flag.
2. Is that profitability sustainable or is it at risk? If it's at risk, why? How significant is the risk, and how likely is the risk to materialise?
3. Is it profitable enough to pay the interest on the proposed borrowing? What is the Debt Service Coverage (DSC) ratio - essentially income divided by cost of the debt? Less than 1.20 would be a red flag.
4. Are there any "interesting" payments to directors?

When looking at the Balance Sheet:-

1. Does the company have a positive Net Asset Value?
2. Is that more than the proposed borrowing?
3. Is the NAV trend positive?
4. Does it have enough working capital (current assets - current liabilities)?
5. If something like a debenture over the company's trade debtors book is offered as security does it cover the loan and could it actually be realised if required?
6. Service based industries (lawyers, accountants, architects, consultants etc) are an automatic red flag. 

Any "no" answers to the above would be a red flag.

A general comment - I dislike complexity, particularly if I can't understand why a company (or its accounts) has been structured that way. For example a group holding company with too many subsiduaries, or lots of inter-company loans.

Then I go back to the "story". Does it still hold up?

Now for two examples. I lent to a gym in Port Talbot. Profitable, healthy subscription numbers, postive NAV etc. Then I read a story in the Economist about China dumping steel, realised that this would have a negative impact on the largest local employer (Tata Steel), and that this in turn would likely have a negative impact on revenues at the gym and sold out of the loan. The story had become less compelling. I don't know whether the gym went under but I think I made the right call.

The second was an engineering firm in the car industry. Right in my sweet spot in that it's a British manufacturing SME doing some good leading edge stuff particularly with electrical vehicles. One of their biggest customers was Nissan.  Again it was profitable, with a positive NAV. The Brexit vote happened as the loan was being launched, and I decided not to invest because my understanding of the risks became much more negative. There was no way I could anticipate the government pledge of support, or that Nissan would invest significantly in electrical vehicle production at its Sunderland plant on the back of it. I think I made the right decision at the time given my understanding of the story, but with hindsight I obviously made the wrong decision.  I regret not having invested - it's not a science .

Yes, it's a little like playing poker - making the right decision and having the wrong outcome is much better play than making the wrong decision and having the right outcome.

Thanks to the question I re-read T Smith's book last night and right at the back... he advises reading accounts from the back to the front.  He believes the principles (kept at the back) are the important bits, while the stuff at the front only makes sense after you have read the back.