How to Read an Annual Report and Understand It?

Reading Time: 9 minutes

A lot of my friends often ask me – how to read an annual report? Well, today’s post is all about this topic – Reading and Understanding Annual Reports by Michael Thomsett.

I hope you enjoy reading my notes as much as I enjoyed writing them. 

  1. Auditing will only disclose the numbers but won’t comment on them That is your task. DON’T ASSUME that if it is an unqualified report from the auditors it is good to go. Still, be skeptical about the numbers.
  2. The chairman/CEO letter in the annual report is most often than not is sheer publicity. Won’t be a frank discussion of what didn’t go wrong. If there is an exception, it is a good sign
  3. Markets and product lines: You can have good knowledge here that what the company does and its markets. This can be used for competitive factors analysis and industry analysis.
  4. The things to look at, in annual reports are financial statements, footnotes, auditor’s opinion letter (if any),
  5. Key ratios and operating results of a decade
  6. MD&A: A little bias is present as management is explaining their own performance
  7. The most important thing to take into consideration is that the primary aim of the Annual Report is NOT TRANSPARENCY.
  8. ARs are for compliance, PR, consistency of performance, and for institutional investors as the bonus of top management are closely tied with the stock/profit performance.
  9. Profit manipulation can be done in two ways: outright distortion of numbers- booking artificial revenues, cap expenses etc and sugar bowl or cookie jar accounting- techniques designed to create consistent growth in sales and profits. These can include spreading in revenues and profits, creating artificial reserves. This is done to make the results seem more predictable. KEEP a close watch on the reserves. And if the reserves have dipped extraordinarily, that is questionable.
  10. Intangibles are difficult to quantify so they should be removed from most of the key ratios
  11. Look at the notes describing assets and liabilities. Sometimes assets (like land) which might have so much hidden value and on the other hand, liabilities might not be reflected on the BS but might have a large value that may dampen the view of the company. If you want to pay too conservative, then take only the bv of assets and include the value of these liabilities into account.
  12. While taking into consideration the revenue part, take a closer look at the operating and non-operation revenue part. And deduct the non-operating portion, be flexible in that as sometimes non-revenue may also turn out to be recurring. DO DUE DILLIGENCE
  13. Also look for deduction of revenue like discounts and returns and calculate the the ratio (13/12) over 5-10 years. If the returns have been consistently rising, then your first question should be why. LOOK deeply at this taking into consideration the proportion of incremental rise/fall too.
  14. Look at the components of COGS. Pay attention to inventory, raw material cost.
  15. Look for GP ratio (assuming that product mix and hence cost basis remains the same) should be consistent or rising (better)
  16. Also consider the expansion of revenue will also translate to more expenses and COGS. Take that into consideration
  17. Also, A BIG RED FLAG when revenues fell and expenses RISING. MORE PROBLEMATIC is falling revenue and rising COGS which can translate to more of stock remeing, rising direct cost like labour and raw material etc.
  18. Three areas to look at in case of numbers: working capital, overall capitalisation and profitability.
  19. If a value while looking at the financial figures of a co over some years look out of line then investigate the reason for that aberration and if it is non rec/ one time aberration then remove it from your analysis
  20. For preliminary analysis, Working capital ratios: CR, QR and Inventory Turnover, Capitalization ratios: Debt ratio and Profitability Ratios: GP, Expense Ratio and Net Return. You should also look for div yield, consistency of dividends, PE ratio, 52 week h/l prices and a review of the trading range
  21. For a firm (especially manufacturing) inventory constitutes a large portion of its CA, so in that case CR won’t be sufficient and we will look at the QR.
  22. Inventory turnover has to be evaluated over time for a company, it is generally seen that higher sales will translate to low ‘turns’ of inventory which is generally not good. A more realistic or a better way to calculate inventory turnover is to take quarterly closing inventories and divide them by 4 (especially for season firms)
  23. Long term debt to equity (ltd + shareholder equity)
  24. CR and DR has to be analysed together because although the co might be in poor economic phase, but CR might be rising. This is due to acc of more long term debt over these years, which translates into cash proceeds
  25. When there is no revenue growth this might be a negative feature. This is wrong because: Cyclical changes, growth has to end at some time in the future, competitive forces in infinite market, earnings more imp
  26. If revenue increases but GP ratio declines it show poor internal controls of direct cost.GM ratio also may change over time and it doesn’t necessarily shows poor internal controls. It can be due to M&A activities. If GP ratio appears to be changing substantially go to the footnotes and specifically go for the heading: M, A and Partnerships. It can be also due to change in product mix so you should also check segment wise cost/expenses/revenue breakdowns
  27. Expense level also should be studied along with Revenue growth yoy. Troubling trend is when revenues fall and expense level rose. Common parlance is stable ratio on %basis or declining
  28. Net Return is net operating profit to revenue.
  29. Long term trend for div yield can be misleading as share price might be dropping but dps might be stable, so in this case div yield m might be rising. Dividends as expected should keep pace with the earnings. It is better to look at div paid every year by the co and the good picture will be a rising trend
  30. There can be problems with PE ratio like disparity in earnings, share prices so it is better to take an average of the earnings over 5 years or take the latest net operating earnings (deep value) or even taking average of the latter
  31. Look for the trading range of the stocks. Look for the prices over a year and you can gauge how volatile is the stock.
  32. Look for footnotes for off balance sheet liabilities like pension liabilities, off bs obligations, commitments or contingent liabilities. Adjust these liabilities when doing studying a company. Most often these obligations wont have a figure assigned to them so the analyst has to use his judgement regarding it.
  33. Also, judgement should be applied to ‘undervalued’ assets reported on the balance sheet of the subject company. Look for the footnotes especially for assets like land, positive points for lands in prime markets. A simple google search will suffice for recognising of prime markets. In such cases, BVPS or net tangible book value may be arcane ratios to analyse.
  34. Any pro forma earnings have to be deducted from the income statement of the co if included.
  35. Pay special and ONLY attention to core earnings of the company as these are the primary products/services offered by the co which are recurring.
  36. Compare the net and core earnings and the associated ratios like pe and net return.
  37. You should also while doing valuation look at the core net worth of the company. Here, you should adjust the off balance sheet items instead of earnings adjustment as a non-recurring cash inflow actually happened and will be reflected in retained earnings as well as cash/stock of the other co whatever may be the case.
  38. If the footnotes seem complex, you are not alone. Just try to skim through the footnotes but never fail to read them.
  39. Most cos don’t bother showing short term borrowings in footnotes and if they do, this is worth analysing
  40. If a company is engage in a business that may attract lawsuits or contingencies, use your judgement in analysing and make necessary adjustments to future cash flows if any you might think reasonable
  41. How to start the basic/primary analysis: calculate the ratios, create the trend of these over the past 5 years or so, look for anomalies in the trends and study them, seek explanations for these aberrations.
  42. Ratios most often tell the effect but equally important is the cause of such performance of companies
  43. Red flag can be if a company seems to complex to study, you should try to read and decipher, but if it still seems complex better to avoid the stock rather than invest.
  44. If there is some part of the footnotes you can’t understand, contact the investment contact of the co, talk to brokers and other investors and research the issue.
  45. Start the analysis of any discrepancy by first looking for obvious reasons and then start looking for for complicated reasons
  46. If you read that the co officials have failed to report the numbers or sign the fin statements, a big RED FLAG
  47. A big redflag is some cos many use their long debt to maintain a healthy working capital position which is quite deceptive.
  48. If the deb ratio has been rising, but the CR is also stable instead of declining it can mean that the co might be capitalising int payments.
  49. Tracking debt ratio and looking at the relationship b/w cash and long term debt will give you a good picture esp when CR might be same even in case of net losses
  50. If the revenues are rising and other non-direct expenses are also rising, this should be looked seriously and to a get a better picture also look at the managers comp.
  51. When there are large adjs done to the intangible assets, it deserves a closer look
  52. Resignation of auditing firm is a red sign
  53. When you read words like ‘restructuring’ and ‘consolidation’ read about it from the footnotes as these involve wrong decisions of the co, not necessary but worth analysing
  54. Look out for too much volatility in the financial results. Always analyse them closely.
  55. Start analysing: Financial strength and position, contingent liabilities, news, volatility, competitive position and diversification
  56. Analyse the co in question’s investments in other cos and see how much in %wise stake it owns. This is a sign of diversifying the business of the co.
  57. The scope of products, diversification initiatives of the company, industry the co operates in and diff geographical markets the co operates in are important points that can be learnt through the annual reports of the co.
  58. Look at the compensation structure of the top executives. Be skeptical if they are earning from the stock highs or the salary.
  59. Cos can manipulate the fin data by recording more of revenue or deferring of expenses to good years
  60. Two accounting methods like POC and bill and hold transactions. The former is recording revenues and expenses during the manufacturing and construction phase only. The latter is recording of revenues before the goods have been shipped to the customers. Trends like rapid growth in accounts receivable, unexplained inc in net and gross profits, surprising differences in closing inventories
  61. Check growth% of revenues and acc rec. If they seem similar it is a warning sign. Moreover, if they are recorded as just journal entries, CR may also seem increased and working capital will also seem better than it actually is
  62. Generally, revenue and inventory grow in tandem with a broad predictability, if there are diff then it may mean that the co is booking revenue early
  63. When revenues increase dramatically and on the other hand earnings didn’t increase, and there is no good explanation, it is a warning. The revenue and net earnings growth should be predictable
  64. To see if the co is capitalizing the expenses: look for %growth in revenues and net earnings, inc in assets in a single year and then falling to the long term asset value, inc in dep for 1-2 years
  65. When sales fall and net earnings rise, a good explanation should exist otherwise it is an accounting manipulation
  66. If the expenses are not reported, current liabilities in terms of acc payables, current ratio and earnings are distorted
  67. There will be differences in operating and net profit and it is itself not a warning sign but adjustments should be made for core earnings to reflect only recurring activities
  68. If you find something in the balance sheet as deferred credits, it is generally an offset account. This is basically included in liab section of the balance sheet and is used as an acc to defer the revenues
  69. In the year the reserves have been rising, the co may increase reserves of bad debts or invent obsolence or other such reserves. This can be a troubling way to show reduced earnings for a particular year

This post has been written by Rohan Seth for The Financial Pandora.


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