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Thursday, July 21, 2011

How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

11 comments:

Jalal said...

I Should be Very Thankful for you. I really didn't expect this post this much early.

Subhankar said...

You're welcome, Jalal.

Hope the post has helped to get you started. I've scratched the surface. A lot more analysis is required.

Ek Veer said...

This is another very useful post from your vast experience.

Bharani said...

Hi Subhankar...Good starting point and thank you for the very useful post...
I have developed interest in reading AR in the last 1 yr even though I have been investing for over 5 years without really looking at it (without much luck as well!!).
One thing I particularly like is the cash position from the balance sheet for calculating EV.

I consider Cash&bank balance, investments (discounted to abt 80% of actual value) and total debt? Is there something else I should consider when calculating the EV? How abt the other current assets? How to note warning signs in these values in the BS?

Please enligten me in these if you have time. Thanks.

scorpio said...

Great stuff, have been learning and will learning from this blog :)

Ek Veer said...

Dear Subhankar ji,

Can you please write any articles on debt market which is as comprehensive as how to read an annual report and cash flow statements explanation. This will be helpful for novice people like us.

Thanks
Ekveer

Subhankar said...

@EV: Appreciate your comments. The debt market for individual investors hasn't evolved very much - the choices for investors are limited to bank FDs/RDs, Post Office MIS/FD/RD/NSC, and debt MFs.

You may want to read my post: 'Start your own risk free FMP.'

@Bharani: Thanks for your comments. Calculating EV is useful for arriving at a company's valuation for those who may want to acquire the entire company. The problem is that most Annual Reports don't provide enough information to calculate the present value of the debt on its books. Only those doing due diligence prior to acquisition are provided with such details.

One should look at all the items under 'Current Assets' critically. Inventories and debtors should increase in proportion to increase in sales. If the rates of increase are higher than increase in sales, it is a warning sign. 'Loans and advances' is a prime area of siphoning off cash. Who are the loans and advances being given to, and when are the likely repayments? Check the schedules to and notes on accounts to find answers.

@scorpio: Thanks for the kind words.

Piyu said...

Hi Shubhankar, I intend to pursue research in the area of investor communications. In light of the new ruling about reports being allowed to be distributed on the virtual medium, what would you say are some of the problem areas vis a viz the communication itself? obviously no more can corporates hide behind the veil of the misplaced-in-transit excuse. well, that's a technicality anyway. But what about the 'talk' itself?
How do you envision consultancies and agencies that claim to specialise in the preparation of this document word their wares differently?

Subhankar said...

Corporate communications, including investor communications, is mainly a PR exercise. Very few companies 'bare their souls' to their investors. Infosys may be a lone exception.

Most companies have web sites nowadays that publish annual and quarterly reports, as well as news items and press releases regularly. So, the days of hiding behind 'lost in transit' are over.

Digital communications have definitely helped investors to access information quickly - but it hasn't led to greater corporate transparency yet.

Consultancies and agencies that prepare communication content don't have much role in the 'what' - only in the 'how'. Last year's award-winning Annual Report of Temptation Foods is a classic example of a junk company trying to cover up their woeful performance with a visually dazzling and over-the-top document.

Piyu said...

I can't help being amused. The 'consultancy' that prepared the past two years' Temptations reports was my last employer. :D
The CEO got me interested in the whole business of annual report making, but put me off with the phaffing.
What also puzzled me was the fact that despite all the hullabaloo about accelerating transparency, the jargon wasn't even attempted to do away with, because of the timelines and pressure of so many clients... legalese seems to come handy in camouflaged disclosures, doesn't it?

Subhankar said...

It's a small world, Piyu!

I've met the CEO and found him to be enterprising and a go-getter. His team is young and energetic - but he needs to keep his clients happy, so the contents depend on what clients want to communicate.

Most companies are caught between a rock and a hard place. If they reveal the facts, no one may buy their products or shares. If they don't reveal enough, they are accused of lack of transparency and governance.