Investors’ guide: How to read an annual report

How-to-read-annual-report

A lot of shareholders will start receiving the annual report of companies they’ve invested in. They can be quite daunting documents. But don’t dismiss them because they are basically your company’s report card on how well they’ve done over the last year. So persevere… it’s worth it.

Here’s my quick guide into what investors should look for in any annual reports they receive.

* Look at the chairman’s address and the directors’ report to gain an idea of how management viewed the past year.

* Compare projections about earnings (profits) made in previous years. If the directors made promises to increase earnings last year, have these been fulfilled? A track record that meets previous expectations provides confidence to investors that the company’s future projections will be met. On the other hand, be wary of a company that glosses over disappointing results. 

* The auditors’ report confirms the company complies with the relevant accounting standards. This provides some comfort to shareholders that the company’s accounts are all legal and in order.

* Think about this – has the company clearly defined its objectives and strategies? The clearer this is, the greater confidence you can have.

* Check the credentials of the members of the board and ensure the company has a couple of independent, non-executive directors. 

* Look at the report to see if the company is generating enough profits to cover its interest payments. This can be determined by dividing earnings before interest and tax (EBIT) by the company’s net interest expense. EBIT will be found near the top of the profit and loss statement and should ignore any abnormal or extraordinary (i.e. one-off) items.

* Keep an eye on the amount of intangible assets such as goodwill, etc. These are not bricks and mortar and therefore more difficult to measure. 

*Take a long, hard look at the cash flow statement. The cash flow shows how much cash the company is actually generating. Beware of a company that reports a falling cash flow over consecutive years

*Look for a consistent record of dividend payments.

The corporate balance sheet in the annual report is an invaluable guide to making sound investment decisions. The balance sheet presents a summary of what the company was worth on the last day of the financial year, and you will find the previous year’s figures for comparison. 

What should you look for? Consider a balance sheet for an industrial company.

Assets – this is what a company owns. It must exceed liabilities, which is what the company owes, or the company will be running a deficit. 

 Usually, there are three kinds of assets listed on a balance sheet. Those which can be converted to cash quickly, say within a year, are called current assets. They include cash, marketable securities, inventories and receivables, which are basically IOUs from buyers of the company’s goods.

Assets that are harder to dispose of, like plant and manufacturing equipment, are known as fixed assets. And sometimes there is a third group called intangible assets, such as patents and copyrights held by the company. 

Liabilities – These are divided into two categories: current liabilities that will be paid off in a year and long-term debt. 

So your first discovery from the balance sheet should be the margin by which the company’s current assets exceed its current liabilities. The ratio of current assets divided by current liabilities is important. Analysts consider a 2-to-1 ratio ample. 

Most of the entries on a balance sheet are reasonably straightforward but there is one area where all may not be as it seems – inventories or stock. A company can consider its inventories as assets because in all likelihood, they are about to be sold and turned into cash. But what if those products cannot be sold? Sooner or later they will wind up as losses. 

You can get a guide on how fast a company is selling warehoused products by calculating and comparing its year-to-year inventory ratio, i.e. sales divided by total inventories, both shown on the balance sheet. 

Ratios which show a decline or wild swings would be a worry. Unsold inventories are a special problem to manufacturers in such industries as computers where new technological advances occur constantly. 

Among the liabilities, take a special look at long-term debt. Could the company repay its debt if it was liquidated? 

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