Muhammad Ali was one of the greatest boxers in history. He once said, “I hated every minute of training, but I said, ‘Don’t quit. Suffer now and live the rest of your life as a champion.’”
You need to have the same mentality while reading the annual report of a company. Suffer through the boredom of reading the annual report of a company.
If you want to become an investing champion, reading annual reports is the price you must pay for success as an investor.
You should be happy that very few have the ability and willpower to read through them. As a former sell-side equity analyst, I can assure you that not even the professionals read through the annual reports. It means that by simply reading annual reports you’re among the top 5% of all fundamental investors.
What Is Contained in the Annual Report of a Company
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The Annual Report of a Company is essentially a formal communication from the management of the company to all stakeholders both internal and external. The annual report of a company is usually written following the end of the fiscal year.
For the vast majority of Indian companies, the fiscal year ends on March 31st.
Although all companies will report the same basic financial data, each company will follow a unique format. In many instances, a company may not keep the format standard from year to year.
The typical annual report of a company will contain the following sections:
- Chairman’s Message
- Management Discussion & Analysis
- Director’s Report
- Corporate Governance Report
- Standalone Auditor’s Report
- Standalone Financial Statements
- Notes to standalone Financial Statements
- Consolidated Auditor’s Report
- Consolidated Financial Statements
- Notes to Consolidated Financial Statements
What Sections You Must Definitely Read in an Annual Report of a Company
As we all have limited time especially those of you that are part-time investors, it’s essential that you maximize your research time.
In my view, you should take an 80/20 approach.
By reading the following sections in an annual report of a company, you’ll get a reasonably thorough overview and understanding of the company’s business for the lowest investment of time.
- Chairman’s Letter
- Directors’ Report
- Shareholding structure
- Management Discussion & Analysis
- Consolidated Financial Statements and notes
I usually start by reading the Chairman’s message to get an overview of the company and the strategic direction that it’s heading.
Generally, you’ll get some insight into the growth targets and an overall idea about the industry dynamics.
The Directors’ reports will state the current year’s financial results, the status of projects underway, and point out any major issues which may have negatively impacted revenue.
This section in the annual report of a company will also contain a list of related party transactions that should be reviewed by all investors.
I’ll discuss common red flags to watch out for in the next section of this article.
Another important disclosure in the annual report of a company is the shareholding pattern.
I prefer to own companies where the promoter has at least 50% ownership. However, the trend in ownership is more important than the overall ownership percentage.
A promoter increasing his stake in a company is positive.
Conversely, a promoter selling down his position is not necessarily a negative. However, I do avoid companies where the promoter has pledged shares.
In addition, I like to see ownership by institutional fund managers whom I respect. For example, Nalanda Capital or the DSP Small Cap Fund.
The next section that I read in the annual report of a company is the Management Discussion & Analysis (MD&A). If I had to read only one section in the entire annual report this would be it.
By reading the MD&A you’ll get a clear understanding of how the company performed in the prior fiscal year.
Additionally, most management teams discuss overall economic trends in their industry. The MD&A will give you a good understanding of the company’s competitive positioning within its industry.
An irritating quirk is that most management teams also include a section on the macroeconomic outlook in the MD&A section.
This section is usually copy & pasted from an IMF report or some other quasi-governmental organization. After reading through hundreds of these economic updates, it’s fair to say that I’ve never received a single economic insight that has made me a better investor.
As a result, I would completely skip the entire economic outlook.
The last section that you absolutely must read is the consolidated financial statements along with the associated notes. The consolidated financial statements provide a comprehensive overview of the financial situation of both the parent company and all subsidiaries.
If you have time, I would recommend also reviewing the standalone financials in the annual report of a company.
However, if you’re short on time and can only choose one then I would review the consolidated financials. You basically want to understand the historical revenue growth and profit growth of the company.
Additionally, you should calculate both operating profit and net profit margins. Ideally, you want to own a company with stable operating and net profit margins.
Companies that have fluctuating margins are most likely cyclical in nature and don’t possess an adequate moat. You also want to see a historical trend of earnings growth.
Obviously, past performance is not an indication of future performance, but it does provide additional evidence that the company’s business model is profitable and management is effective.
What Are Some Red Flags in the Annual Report of a Company
While reading an annual report of a company, your main job is to assess management quality. The first section you should analyze is management compensation.
Your return as a minority shareholder is solely dependent upon the promoter’s interests aligning with yours.
If he’s solely interested in enriching himself, you’ll never see a return on your investment no matter how great the company is and how fast it’s growing.
The easiest method to assess whether management is paying themselves excessively is to determine whether compensation is below the prescribed limit mentioned in Section 197 of the Companies Act.
If you do a search for Section 197, you’ll typically find a disclosure made by the company.
Remuneration for any single promoter who is a managing or whole-time director can’t exceed 5% of net profits. In my experience, most high-quality promoters limit their compensation to within 2% to 4% of total net profits. This includes both commission and their fixed monthly salary.
If a promoter is paying themselves 5% or more of net profits it’s egregious and a red flag.
Another remuneration related red flag is a promoter who consistently increases his compensation even if the company shows a decline in profitability.
You should avoid any company where management’s compensation isn’t linked with performance.
The final issue related to management remuneration is excessive stock compensation in the form of warrants.
They are usually marketed as a way for a promoter to infuse capital into a company.
However, in most cases, there are much cheaper methods of raising capital including raising debt, collecting receivables, and issuing direct equity. Warrants are basically called options on which a promoter can speculate on his company’s share price.
As a general rule, I would avoid owning any company where a promoter has issued warrants to himself.
The Auditor’s Report to Management in the annual report of a company also contains a section called Key Audit Matters where they include any pertinent issues that should be highlighted to the Board of Directors and shareholders.
The auditor also issues an opinion as to the integrity of the financial statements. It’s rare to find any major issues but it does happen from time to time.
The next section you should review in detail is related party transactions. A common practice that unscrupulous promoters utilize is inter-corporate loans.
The promoter takes a loan from the company and then eventually defaults.
In this scenario, common shareholders are left holding the bag. In most instances, the company provides loans to the promoter at below-market interest rates or even interest-free.
The shareholders are again the losers in this scenario as the company must borrow funds from the bank or bondholders at much higher rates in order to subsidize the loans made to the promoters.
In general, receivables will rise in proportion to revenue. However, a significant increase in receivables days is a red flag.
It could mean that management is providing more lenient credit terms to customers or pursuing an aggressive revenue recognition policy.
It’s best to analyze receivables days over at least a 7-10 year period.
Frequent acquisitions are also another red flag as management teams can use the process of merging financial statements to hide skeletons in the closet. Any company pursuing “transformational” acquisitions on a yearly basis should be reviewed carefully.
In summary, the easiest way to differentiate yourself from other investors is to do the hard work of reading the annual report of a company as much as you can.
If you’re strapped for time, it’s not necessary to read through the entire report.
By judiciously focusing on the most important sections, you can get a comprehensive overview of the company’s business and prospects. You don’t have to enjoy the process but you’ll definitely love your improved investment results.
The next time that you’re suffering through an annual report remembers that Muhammad Ali became a champion despite hating training.
If you’re willing to pay the price, you too can become an investing champion. The only thing is – read the annual report of a company. Nothing else.