The fundamentals of company accounts are really very straightforward, because they conform to a completely standardised format that's essentially the same for every company, from your local corner shop all the way up to BT. It's the add-on documents and all the supplementary twiddly bits that seem to make it so complicated.

A company's accounts actually contain only three basic items:

If you're reading the accounts in the annual report document, then the directors' report at the start contains details of any forthcoming dividends (see Chapter 2 on dividends). And 98 per cent of people who read the accounts probably ignore the couple of pages of notes at the end. Everything else is just additional detail that the company may or may not decide to tell you about.

Now, don't get the impression that I'm instructing you to ignore the small print, because I really don't want something terrible buried in that small print to catch you out. But you can generally get along just fine by focusing on the three statements I've just mentioned: the profit and loss statement, the balance sheet, and the cash flow statement.

The accounts you're about to read are based loosely on the trading results of a major British company with operations that extend throughout Western Europe. The company's multinational structure means that it isn't really just one company, but rather a whole group of companies under a single umbrella. And, like many companies of a similar size, it has been busy changing its shape in recent years, buying new divisions and selling off old ones. And, as you can imagine, this process of change plays havoc with a company's accounts.) I'm going to run you through the basic calculations here, focusing particularly on the parts of the accounts that are highlighted in grey.

Table 17-1 presents the Group Income Statement (that is, the profit and loss statement) for the whole organisation.

The first item on the profit and loss sheet is the Revenue, otherwise known as Income (or, more prosaically, Turnover). As the name suggests, it's all the money that came in from operating the business during the year, and it was a bit more than £900 million in 2007.

Next comes the Net operating expenses, which basically tells us the cost to the company of running its operations during the year. The figure is £830 million, on the second line, written in parentheses to show that it's a negative number (a standard accounting tradition).

Next comes a Group operating profit of £70.3 million, arrived at by deducting the Net operating expenses from the Revenue. But sadly, you need more than staff and equipment to run a transport empire: £7.43 million of finance costs also have to be paid, representing loan interest and so on. Even the fact that the company has another £1.94 million of revenues from various other places can't stop the Profit on ordinary activities before taxation (that is, pre-tax profit) from dropping to £64.83 million.

Take away £11.61 million in tax, and you've got a Profit for the year from continuing operations of £53.22 million. Or post-tax profits, as you probably call them. These post-tax profits can then be distributed to the shareholders as Dividends per ordinary share – or the company can partially withhold them if it wants to build up its cash reserves.

In 2007 no activities were discontinued (that is, the company didn't sell anything off or close anything down), so the figures are nice and simple. In 2006, however, it sold off one of its divisions that was bringing in £7.04 million of profits. For the sake of clarity, I've left these discontinued operations in the table so you don't waste your time scratching your head and wondering why the end-of-year profits went up only marginally from £44.97 million to £53.22 million. In practice, of course, the fact that the figure's left in allows you to see very easily that the effective profit comparison has in fact risen from £37.94 million to £53.22 million.

If you skip now to the second-to-last item, Earnings per share from continuing operations, you see that the company's made what amounts to a 25.72p profit for every share it's issued. Diluted earnings per share, however, equals a marginally smaller 25.66p. That's a fancy way of describing a mathematical allowance for all the stock options, warrants, employee savings schemes, and other convertible gubbins that the company's already issued, all of which might one day get converted into shares. (But equally, they might not.) The 'diluted' figure gives you an idea of how things may look if they all get converted. The exercise of preparing such a 'worst-case scenario' may seem slightly absurd, but if it calms the investors' worries, why not?

In practice, Arriva's decided not to distribute all of that 43.5p cash to its shareholders: instead, it's declared a dividend of 22.65p for 2007, probably paid in two six-monthly instalments. The rest of the money goes back into the coffers to fund future growth.

The balance sheet's probably the trickiest part of the whole annual accounts system – see Chapter 8. Rarely do you find such a motley collection of overdrafts, debtors, creditors, tax bills, and pension liabilities, all bundled together in one place for the purposes of computing what the accountants rather optimistically describe as the 'value' of a company.

Table 17-2 presents the group balance sheet for our company.

Notice that on a balance sheet accountants don't try to say what's been going on during the year, the way they would with the profit and loss account. Instead, they just take a snapshot of how things looked at the very end of the period, and freeze-frame that snapshot for posterity, in all its transient glory.

The purpose of the balance sheet is to set out what the company owns (its assets) and what it owes (its liabilities). Assets are divided into fixed (or non-current) assets – buildings, plant and equipment, goodwill, investments, and so forth – and current assets, such as inventories of stock or cash in the bank that has a more transient value.

The largest part of the current asset section, however, is the one that always makes me laugh. Trade and other receivables, as mentioned here, is the term that describes the debts other people owe to the company. Many small businesspeople somehow fail to think of their debtors as assets when they'd really rather have the debtors' money in their pockets instead. But for accounting purposes, that's the description. The money that people owe you is part of what makes your business more valuable. Counter-intuitive but true.

So our company had total assets of £971.06 million at the end of December 2007. Against that, it had £640.76 million of Total liabilities, comprising both Current liabilities and Non-current liabilities, leaving the company with Net assets of £330.30 million on the final day of its financial year.

To go back to our company, let's look now at the composition of those liabilities. £245.93 million was the sum the company owed to its trade creditors – rather more than the amount other people owed it. (It happens to be a largely cash-in-hand sort of business.) It owed £53.06 million to the bank in short-term loans and another £91.44 million in 'non-current' loans, which would normally mean mortgages, bond issues, and long-term borrowing commitments.

You may want to compare the Current assets with the Current liabilities. By dividing the two into each other, you arrive at a ratio called the liquidity ratio, which can give you some useful clues as to whether the company's facing solvency troubles. This particular company obviously has no problem, because the value of its assets outweighs its liabilities by more than 51 per cent (that is, the ratio's 1:1.51). But if it's below 1 you'd be entitled to think that only a miracle can save the company – or a buyer who didn't mind taking a very big gamble on sorting it out and bringing the company round! These are the kinds of situations in which banks are liable to pull the rug on a company's loans. Indeed, it can actually be an offence for a company to carry on trading in this position. !

Some people like to refine the liquidity ratio still further by discounting the value of all stock from the current assets, on the reasoning that stock's worthless if people won't buy it, or if the company isn't around to sell it. The so-called acid test ratio can be quite a problem for retailers in hard times when the markets have gone quiet. But once again, our company isn't bothered because its stock inventory of £18.50 million is really very small in relation to its turnover.

The final part of Table 17-2 shows Total equity, which was worth £330.3 million at the end of 2007 – and, by no coincidence at all, that's exactly the same as the £330.3 million figure logged for the company's net assets. There'd be something seriously wrong with the calculations if the two figures didn't tally.

Where does this equity account come from? Well, the greater part of it – some £319.59 million – comes from Shareholders' equity and another £257 from Retained earnings (that is, cash in the bank).

A lot of other items are in the mix, but I'd be going in way too deep if I tried to analyse them here. For the moment, let's just focus on the key elements and save the complications for another day.

For some reason the cash flow statement seems to be the Cinderella of the accounts business. And that's a pity, because it can reveal a lot. You may get so involved with the profit and loss account, and with the state of the company's assets, that you forget to ask which parts of the business are generating money and which ones aren't.

Each company's cash flow statement is slightly different, because each does something slightly different from all the others to earn its money. So making generalisations is quite hard. But in principle, the stock market wants to know:

Look at Table 17-3. Notice that, for our sample company, in 2007 at least, the end-of-year position was really pretty much the same as in 2006. A £2.5 million decrease in the cash situation was small beer compared with the sheer scale of the £900 million turnover – but in fact there were some big transactions going on behind the scenes.

For instance, you see that the cash generated by operational activities rose by pretty well 100 per cent during the year, largely due to expansions of the business. And after tax, the Net cash inflow more than doubled. But the company stepped up its purchases of property, plant, and equipment from £59.92million to £104.67 million even though its revenues from selling things off rose by only £12 million, from £27.55 million to £39.33 million.

Although the volume of short-term loans decreased by around £18 million, it was effectively outweighed by a £32 million rise in longer-dated debts. And the amount paid out in dividends went up substantially from £13.9 million to £18.9 million.

This all looks rather boring. So where's the excitement?

Well, the statement is stable, on the whole, and it paints a reassuring picture of the company. But if the finance director of a company is playing fast and loose with his shareholders' cash, wheeling and dealing and constantly shifting the debts from one place to another, you can see it in the cash flow statement.

Many bargain-hunters get really turned on by a big cash balance in the bank, especially in a small company, and they'll always tell you to pay special attention to how much money's in the coffers. They're not wrong, either.

Situations do sometimes arise where small companies' share prices fall to the point where their market capitalisations are quite literally smaller than their liquid cash assets. Barring major disasters, these situations are about as close to a no-brainer as you can get. Either the company's in the process of dissolving itself and has stopped trading – something that sometimes happens to investment trusts (see Chapter 14 on trusts) – or else a predator will soon be along to scoop up the company for its cash pile and the shareholders will be well rewarded. Either way, the point's worth remembering.

Just a reminder of something I say at various points throughout this book. Accountants and auditors have a surprising amount of leeway in deciding how to set down fixed assets like property in a company's accounts. They can use wide discretion in calculating the value of intangibles such as brand names and patents. And, as many investors have found to their cost, some of them never quite seem to run out of enterprising ways to cloud the issue where debts are concerned. Chapter 9 covers the many fascinating tricks and manoeuvres surrounding asset declarations.

The statutory accounts that companies normally provide to the regulators cover only the last two complete financial years. That's all that the rules require them to provide, and it gives the stock market enough information to be able to compute all the things they need – things like 'trailing averages' (which give you average performance levels over a period of time), or 'historic dividend yields', which often involve such incredibly complicated maths that no two press sources ever seem to be able to come up with the same figures.

But, for the really diligent investor, it's also worth looking out for tables that present a longer-term view of a company's financial background. It's all very well knowing that last year's turnover was better than the year before, but don't you think it would be helpful to know that the year before /that/ was an even better year – and therefore, that the low year in the middle was probably just an exception to the usual trend?

That's why many companies will helpfully supply you with five-year statistical summaries that can help you to get a better long-term view of how your company has been getting on. The chances are that the company's website will have such a table tucked away somewhere on its 'investor relations' page. But you can also find similar five-year company summaries listed on third-party websites such as Digitallook, which supplies the statistical material for the Motley Fool in the UK.

The website at http://fool.digitallook.com will get you started.

A word of warning, though. Although these independent websites try their best to keep their information up to date, they don't generally accept any responsibility for having got things wrong or perhaps out of date. Remember, they're dealing with vast amounts of data for vast numbers of companies, and it's quite easy to get small details wrong, or simply not to notice that some figure has been retrospectively 'adjusted' in a way that might change our perception of it.

What sort of 'adjustments' are those? Well, it's not entirely unknown for a company to have to restate its last year's trading figures if the financial regulators are at all unhappy with them. Very occasionally, a company will be required to rejig its results for several years going backward!

More probably, complications will result from a recent merger or acquisition which obliges the company to combine the results from two different operations – each of which might be using a different accounting system as well as different financial year-ends! The resulting figures will inevitably be an untidy collision of estimates, occasional obfuscation and sometimes blind guesswork, especially where intangible factors like brand names and trademarks have to be valued.

And those very approximate figures will need to be reworked backwards into the last five years' accounts as well if we're to get any idea of 'like-for-like' performance.

Then there are share splits (otherwise known as scrip issues) that might make it look to the superficial eye as though your company's shares are worth less than they used to be – whereas a closer look would reveal that the investors had actually been issued with free shares that effectively compensated them for the apparent 'loss'. (I talk about scrip issues in Chapter 9.) An information provider who's really on the ball will have reverse-calculated the effects of the scrip issue into his back figures – but accidents will happen, and they sometimes forget.

Enough of this – I think you've got the idea by now. Five-year statistical views are a really great tool to have in your investor's armoury, and they can often alert you to a long-term trend that you might not have noticed if you were just looking at the last year's figures. But do treat them with a large pinch of salt. And if you ever find anything that looks too good to be true, then remember, it probably is. Go off and check the company's historical charts for corroboration, or do some in-depth research before you lay down your money on something that might turn out to be a misunderstanding.