INTERPRETING AN ANNUAL REPORT
Most existing or potential investors will hardly
ever go through a company’s annual report, assuming that it contains the information which would not be understandable to 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 on
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 that you hold in your portfolio. How many of you have taken a 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 a 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 favorably. 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 the most efficient and most effective. In other words,
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 understand what 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 of
financials, an 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 yearend, 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 favorable for company; and whether the management was able to perform
well during the economy’s rollercoaster ride.
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 also mention 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.
MANAGEMENT DISCUSSION AND
ANALYSIS (MDA)
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 economic scenarios. This section makes it
easier to see an overall snapshot of how successful, or unsuccessful, the
company has been over the previous year.
REPORT ON CORPORATE GOVERNANCE
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 are the
composition of the board of directors, sub-committees, and attendance records of
directors during meetings. Also, relate the remuneration paid to the directors with
profits earned by the company. Analyze whether the profile of independent
directors matches 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 bottom line.
ACTIONS OF TOP SHAREHOLDERS
Apart from disclosing their broad shareholding patterns,
listed firms are now required to disclose far more information from FY15 onwards
with regards to details of what their top shareholders (promoter as well as
non-promoter) 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. Coal India’s latest annual report
reveals that LIC, which is a top institutional shareholder in the company, has
increased its stake from 2.10 percent to 7.24 percent over 2014-15.
INDEBTEDNESS OF THE BUSINESS
Until now, getting a bird’s eye view of a 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.
SALARY STRUCTURES
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 an 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 increase in employee salaries to see whether
or not both are in line with the company’s bottom line.
AUDITOR’S REPORT
This section provides information on comments by
auditors on the financials of the company. Check who the auditors of the
company are, 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 the change in accounting policy, if any,
will be highlighted in this section. The auditors, when they are in agreement 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. Analyzing numbers from this section help us to
check the financial health of the company.
The Profit and Loss Statement: It reports a
company’s revenues and various kinds of expenses that 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 bottom line of the profit
and loss statement is labeled as net income. If the net amount (or bottom line)
is negative, there is a net loss.
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.
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. The cash flows
from the investing activities section show 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 include 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 an 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
Contingent liabilities are possible future liabilities.
Due to a 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 a
tedious exercise for the first time. However, it is advisable to analyze 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.
