Reading An Annual Report

Most existing or potential investors will hardly ever gothrough a company’s annual report, assuming that it contains information which would not be understandableto non-finance persons. However, an annual report is like a door that opens into a company’s entire operations and provides a clear picture of the path it is treading 

Once a year you may receive a hard copy of an ‘Annual Report’ as a bulky package by post for each of the listed companies’ stocks which you hold in your portfolio. How many of you have taken due interest to open and read it? Most of you do not bother to even glance through it and such reports are usually sold to the used newspaper vendor. Very few experienced and amateur investors alike will use the information contained in these reports to make sound investment decisions. You can also get annual reports from a company’s website under its ‘investor relation’ section or the BSE and NSE websites if you are not shareholder of any particular company. Annual reports are one of the tools available to serious investors that may help them build a better understanding of a company — its current operating results, its financial health, and its likely outlook. 

Most companies exert considerable effort to produce an attractive annual report and, quite reasonably, try to 
accentuate the positive by highlighting information that readers will interpret favourably. However, behind all 
the pretty pictures, there is an abundance of valuable information that provides an investor (or a potential investor) with a better understanding of the company.One has to be careful while going through the annual report as there is a very thin line between the facts presented by the company and the marketing content that the company wants you to read. While each company attempts to produce its own unique report, the general format of the annual report is largely standardized, which makes it easier to find specific information and to make comparisons with other companies. 

People read annual reports in different ways. Some investors even prefer to start at the back and work their way to the beginning. It makes no difference how you read them, as long you absorb the essential points of the business and its financial condition. However, there is a good way to tackle these reports that is both most efficient and most effective. In another word, as an investor you don’t need to read the annual report like a novel — from cover to cover. Instead, approach it like a newspaper and jump around to the relevant sections to get the answers you need to decide whether you should buy or hold on to the stock. Let us briefly go through the various sections of an annual report and understandwhat the company is trying to communicate through it. Also, we would like to share information about the few new disclosures in the FY15 annual reports of Indian companies. 

Director’s Report 

This section provides a brief summary on financials, explanation of the financial results, and key developments in the company. Other than the financials, it talks about the company’s capex plans in the pipeline or executed during the year, employee productivity, near-term growth plans, order book as on the financial year end, etc. The terms used to discuss the operation of the company vary depending on sectors. Therefore, to get some knowledge about industry terms, use the glossary to get better insights. Read the past three to five years’ director’s report to see whether the management has achieved the set revenue target over the years; whether strategies adopted over the years were favourable for company; and whether the management was able to perform well during the economy’s rollercoaster ride.

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Also, look at the tone of the director’s report in view of the entire annual report. Ideally, it would sound positive in the good years and negative in the bad years of the company’s performance. It will also talk about developments that have happened after the balance-sheet date. Further, it will alsomention the products and services introduced during the year and their potential, besides abnormal expenditures or negatives that have hit the margins. Then there is an assessment of the current year’s prospects, which is important for fundamental analysis.

This is one of the most important sections in the annual report. The most standard way for any company to start this section is by talking about the macro trends in the economy. They discuss the overall economic activity of the country and the business sentiment across the corporate world. If the company has high exposure to exports, they touch upon the global economic and business sentiments. This section provides information on trends in the industry, SWOT analysis of the company, insights on key-line items of financial statements and risk factors or concerns affecting the company’s performance. You will get relevant information to understand the industry while reading this section. An investor should read at least three to five years’ of MDA to understand the trends of the company in different economy scenarios. This section makes it easier to see an overall snapshot of how successful, or unsuccessful, the company has been over the previous year.

This section gives insight on corporate governance followed by a company; composition of the board of directors; brief background information on directors and independent directors of the company; attendance of directors at board meetings and annual general meetings; remuneration of directors; re-appointment of directors after completing the term; composition of sub-committees; etc. The key things to look here is the composition of board of directors, sub-committees and attendance records of directors during meetings. Also, relate the remuneration paid to directors with profits earned by the company. Analyse whether the profile of independent directors match the requirement of the company as per the sector it is operating in. Good governance can increase a company’s valuation and positively impact its bottomline.

Apart from disclosing their broad shareholding patterns,listed firms are now required to disclose far more 
information from FY15 onwards with regards to details ofwhat their top shareholders (promoter as well as nonpromoter) did with their stock over the past year. These disclosures are useful to gauge if the promoters have been pledging or revoking the pledges on their shares, or if a firm’s promoters are buying into or selling out of the firm. The details on what the top ten non-promoter shareholders did can be even more interesting. This is a good gauge of what key FIIs and domestic institutions such as LIC are doing with their holdings. TCS’s latest annual report reveals that LIC, which is a top institutional shareholder in the company, has marginally decline its stake from 2.51 per cent to 2.46 per cent over 2014-15
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Indebtedness of the Business

Until now, getting a bird’s eye view ofa company’s overall debt position was a Herculean task, requiring you to look through multiple notes and schedules to gauge the company’s debt situation. The new disclosures lay it clearly in a tabular form with details like a) amount of principal due, b) amount of interest due, and c) new borrowing or repayment during the year. Not only does this statement give you an overall, stripped-down view of the company’s debt position, it also captures the changes to that debt due to foreign exchange fluctuations or changes in interest rates.

Annual reports were always required to lay down the break-up of the pay packets for their directors including their MD, CEO and other key personnel. But this year on, they are required to disclose far more, including: a) ratio of remuneration of each whole-time director to the median remuneration of all employees of the company, b) increase in pay for top employees over the previous year versus increase in median remuneration, and c) increase in top management’s pay relative to the company’s performance. These are useful bits of information  to gauge if a company’s top managers or directors are overpaid in relation to the company’s staff and peers in the industry. You can now compare the increase in remuneration with the company’s profit growth in percentage terms as well as compare this with the increasein employee salaries to see whether or not both are in line with the company’s bottomline. 

This section provides information on comments by auditors on the financials of the company. Check who the auditors of the company, including the internal audit team. Since many third-party users prefer certification of financial information given in annual reports by independent auditors to ensure it is authentic, many companies rely on auditor reports to certify their information to attract investors, apply for loans, and improve their image. 

The information on change in accounting policy, if any, will be highlighted in this section. The auditors, when they are in disagreement with the management, qualify the report. It’s an independent source for verifying the correctness of statements and facts mentioned in annual reports. The auditors also add notes to balance-sheets which highlight lapses in compliance with rules or other abnormalities, deferred revenue expenses, wrong classification of expenses and treatment of deferred revenue expenditure.

Financial Statements 

This section is one of the most important aspects of an annual report. It provides detailed information on profit and loss accounts (income statement), balance-sheet as on year end, cash flow statement and schedules of the financials for two years. Analysing numbers from this section help us to check the financial health of the company. a) The Profit and Loss Statement: It reports a company’s revenues and various kinds of expenses which occurred during the year and you can compare this with the previous year. If the net amount of revenues and gains minus expenses and losses is positive, the bottomline of the profit and loss statement is labelled as net income. If the net amount (or bottomline) is negative, there is a net loss. b) The balance-sheet highlights the financial condition of a company and is an integral part of the financial statements. It offers a snapshot of the company’s health. It tells you how much a company owns (its assets) and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called net worth or shareholders’ equity. c) A cash flows statement tells you how much cash went into and out of a company during a year. You may wonder why there’s a need for such a statement but it can tell you if the company is running out of money while being profitable. A good look at the statement of cash flows for such companies can warn investors that rocky times are ahead. Companies can generate and use cash in several different ways. The statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities, and from financing activities. Investors should look closely at how much cash a firm generates from its operating activities because it explains how well the business is producing cash that will ultimately benefit shareholders.
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The cash flows from the investing activities’ section shows the amount of cash firms spent on investments. Investments are usually classified as either capital expenditures - money spent on items such as new equipment or anything else needed to keep the business running - or monetary investments such as the purchase or sale of money market funds. The cash flows from financing activities’ section include any activities involved in transactions with the company’s owners or debtors. For example, cash proceeds from new debt, or dividends paid to investors would be found in this section.

Many companies provide financial statements twice. The standalone financial statements represent the standalone numbers or financials of the company itself and do not include the financials of its subsidiaries. The consolidated numbers includes the companies (i.e. standalone financials) and its subsidiaries’ financial statements.

Notes to Accounts

These non-financial notes relate to details about financial numbers and are extremely important for appropriate interpretation of the company’s financials. You will get information on accounting policy followed by a company, depreciation method, forex losses / gains, segmental reporting, inventories, liabilities, leases, etc. It will be helpful if you read notes to the accounts section of the last three to five years.

Contingent liabilities are possible future liabilities. Due to lack of certainty, they are mentioned below the balance-sheet. It may have a significant impact on the company. It’s important to understand their nature to assess the possible impact they can have on the company. It gives a sense of the risk and concerns associated with key assumptions made during the analysis. You may find that reading an annual report is tedious exercise for the first time. However, it is advisable to analyse at least two to three years’ past annual reports of a company to understand the various operations of the company, financials and management’s view or perspective during various economic trends. By doing so, you will avoid wasting unnecessary time on companies that do not meet your investment suitability. Investing is a discipline that rewards those who are continuously learning.