How to read an Annual Report?

Many years ago, when cheap internet, commodity computer hardware, and tonnes of good-quality free resources on investing had not hit the Indian market, SEBI made it compulsory for every listed company to send its shareholders (no matter how minuscule their shareholding in the company) a printed copy of the annual report. As printing was a costly affair, companies had an incentive to restrict the size of those annual reports to a mere few pages- audited numbers, some promoter backgrounds and that’s about it!

But with the advent of the internet and the ease with which a document could be made available to millions of people, companies found it prudent to market their success in the annual report along with the dry numbers. And thus was born the era of free market information. Good companies shared more and more data about their operations, their challenges, their strategies and the future which the shareholders could look forward to. From being a backward looking statement about a company’s performance, the annual report became a forward looking treasure trove.

As data became more abundant, so did the depth of financial analysis!

The annual report of a company is a treasure hunt competition- it tells you a lot about how things have been for the company, the market and how things should be like in the near future. This plethora of tacit innuendos gives the inquisitive mind plenty of clay to build bricks out of!

And in all honesty, banks, investment firms, HNIs, and every other form of investor looks closely to each and every line of the annual report to arrive at a decision about the value of the company.

Now if you are new to the world of investing, or you are just an individual investor with a full day-time job, you surely will be taken aback with the volume of information one finds in the annual report. In all sincerity, 200 pages of annual report reading, just to get a hang of one company is not everyone’s cup of tea!

But fear not, in this article, we will help you steer through the pages to get exactly what you need. We will help unravel some of the mystery about ‘How to read an Annual Report’.

First things first, get a copy of the annual report for a company which invokes the investor in you. For a newbie, you should start with a company that fascinates you, something that you have some prior knowledge about- what is sells and what makes it special to you. Now you can get yourself a soft copy of the latest annual report for any company through a simple Google search. If you are not comfortable with a soft copy, feel free to get a printed copy. The first few annual reports will build your base about how you should read an annual report.

The first few pages of the annual report, usually comes with an address from the promoter. Sometimes it is pretty useful, sometimes it’s just fancy talk, and sometimes it is just not present! A good promoter address usually summarizes the company’s performance, what went right for the company, what went wrong, and a general view of the industry.

Moving ahead you can skip the fancy graphs on financial performance, but you should not and cannot skip the data on physical performance. This is what will help you anchor the financials to a per unit basis, and will be your guiding contrast for comparing the operational and economical efficiencies of the companies.

To illustrate the point, let’s take an example from the cement industry. The information about quantity of cement sold can easily help you figure out the price for which a tonne of cement is sold and the EBITDA/tonne of cement sold. Usually we focus too deeply on the financial statements and forget to connect the financials with the physical performance, which leaves a lot of unearthed information that might have helped an investor know a lot more about the health of a company’s operations.

Moving on, seek out any information about operations that might be scattered on those pages, like captive power capacity, number of employees, number of new projects, number of patents applied for and obtained, etc. These operational metrics are specific to the industry in which the company operates, and this is what converts the financials numbers of companies to insights. These help turn fishes and eggs into oranges. And oranges you can compare with oranges!

Then comes the ‘caviar’ of the annual report- Management Discussion and Analysis.

This is the ‘crème de la crème’ of the information provided in the annual report. You can skip absolutely everything in the annual report, but not this! This is where the value of the company lies.

The management discussion and analysis, often called the ‘MDA’ by analysts to push up the ‘swag’ meter, is a detailed discussion on the industry, the present performance of the company, any material changes in the company, the strategic initiatives pursued like mergers, acquisitions, spin-offs, etc., the detailed analysis of what went wrong for the company, and finally what the company is doing to make all things that went wrong for the company during the preceding year into righteous value creation.

It is worth noting that it is in these pages that you actually get to make sense of what the company has been going through over the last 365 days. And this coherent story will help you figure out how the numbers in the financial report changed over the last year- why the EBITDA fell, what extra-ordinary expenses/income the company incurred, what caused any disruptions in operations, what legal proceedings the company faced and how they fared at it, any major decision about dividends, etc. You should make it a point to scrutinize each and every detail in the MDA.

One more thing that an investor should do, to support the information in the MDA is to search for the ‘concall transcripts’ of the company. Now this might be outside the annual report, but these are like the personal interview sessions of the company’s top management. Every quarter, when the company declares its quarterly performance, a concall is arranged for the investors to seek clarifications or insights from the management. These are recorded and penned down for later references. These usually come along with quarterly investor presentations. All these will help you keep track of the company’s intentions and mind-set.

Once you have completely devoured the MDA, you can skip a few pages to read the shareholding pattern. What you should check for here is if there is any material change in the top stakeholders in the company. Usually there are two things to look for- is there a change in the principal promoter or is the share being hopped around between group companies. In either situation you should slow down your analysis pace and focus on what is actually happening among the top shareholders. It might indicate an exit plan or financial jugglery to show that the numbers are afloat!

Also look into the change in pledged shares of the top shareholders of the company. These are the stakes of the top shareholders (usually promotoers) that has been offered as collateral to banks or other lenders to raise debt. Thumb rule is that the lower the pledge, the better the company’s fiscal security.

From here on, you will find lots of reports. Steer through them with a light read. The next pit stop is the auditor’s report on the financials.

In the auditor’s report you need to seek the phrase “However, the auditor noted”. This is where you should read with full attention. Usually these are the red signals in the financial reports that the company was not able to explain adequately to the auditors. Sometimes these noting are about subjectivity, but at times these are pretty objective in nature, with consequences.

Now before you jump to the financial statements, you should read the guidelines used for preparing the financial statement- if not everything, at least fixed asset valuation, depreciation and revenue recognition. But it is advisable to read them all.

And with that, the ‘English’ of the annual report comes to an ends, and numbers begin.

I’ll leave the financial analysis portion for a separate article.

Feel free to pick up any random annual report, and apply the aforementioned to see if you can cut through the clutter and get the most out of what the annual report has to offer.

Happy investing!

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