An Annual Report a Day Keeps the Losses Away; Get the Most from Reading an AR

  • Jul 11, 2020 AEST
  • Team Kalkine
An Annual Report a Day Keeps the Losses Away; Get the Most from Reading an AR

Summary

  • The Annual Report is an extensive document of a business and its captures the performance of the business over the past financial year. It allows investors to understand the business qualitatively and quantitatively.
  • Readers often seek to check information that are relevant to them as annual reports are quite extensive. But they should also consider checking some critical information that are only available once in a year in the annual report.
  • It is imperative for investors to know the business, management, performance, quality – and annual reports are primarily the go-to documents.

“I read the annual reports of the company I’m looking at and I read the annual reports of the competitors- that is the main source of material”- Warren Buffett, arguably the worlds best investor.

Annual reports are perhaps the best source of information for any serious investor worth his/her salt. Although the whole annual report may not be written by the company’s management, the management commentary section of the report provides valuable insight not only into the business, but also into the minds of the stewards of the business- the management.

Annual report lays down all the necessary information with regard to the business operations, such as views of management, detailed information on board and management team, related party transaction information, auditor observations, and the all-important financial statements.

Thus, all professional and seasoned investors dig deep into the annual reports to thoroughly understand the business and the industry at large.

Annual Report – A Platform for Management to Communicate  

The annual report is an avenue for the management to clearly communicate with their stakeholders.

All companies exhibit their long-term and short-term ambitions in reports, but winners are likely ones that consistently achieve those ambitions with adequate risk management, integrity, ethics, stakeholder management and values.

Assessing management behaviour is a key aspect of an investment process for investors. It is even more critical during periods when business was not in the best shape and to gauge the management capabilities in drawing strategies that pull the business out of those conditions.

Readers also get to know the honesty and transparency of the management when reading multiple annual reports of the business. For investors, it often comes as a shock when companies disclose frauds or misconduct.

Read Reports and not a report

It is imperative to scan multiple annual reports of a business, enabling a reader to compare the ambitions and achievements of management over periods, which should include glory as well as gloomy days.

Amazon Annual Report 2019 (Source: Amazon)

 

The above image is from Amazon Annual Report 2019, where they have published a letter to shareholders which is over 20 years old. Every year Jeff Bezos reminds his investors of the Company’s vision, which he clearly laid out in the 1997 Annual Report. This gives the investor an opportunity to benchmark words with action and take a clear long term view of the business. Amazon has gone on to deliver its shareholders returns in multi folds over the years, and handsomely rewarded its patient investors.  

Also read: Dividends versus Annuities: Why dividends are still important

Annual Report- Gateway to Financial Health of the business

Reliance Worldwide Corporation Limited (Source: Annual Report 2019)

 

The listed entities are mandated to provide all the financial details of the business in accordance with the accounting standards. In the Annual Report, the board puts out the financial statements of the business, that includes the Profit and loss statement, the balance sheet and the cash flow statement. In addition to all this, the icing on the cake is the foot notes or notes to accounts.

Amateurs start and stop at profit and loss account; professionals start at balance sheet and stop at foot notes.

Annual Report provides an investor to go into the fine prints of the numbers, for instance, Non-cash items like depreciation, employee stock options, impairments, and goodwill revaluation.

All these have a direct bearing on the business in the long term; thus, it should be carefully checked by the investors. Business can declare misleading profits by manipulating non-cash items in the balance sheet or income statements.

By going through an Annual Report, an investor can understand the accounting process followed by the company.

With the proper understanding of the accounting standards, an investor would be able to judge if the board is following aggressive or conservative accounting practices. For instance, a company can incur high or less depreciation of assets or provide an unreasonable life of asset like considering a long life for the asset, which is not the industry case. Similarly, investors check material impairment to intangible assets, which impacts the net profit of the business. All this information is clearly laid out in the Annual Report.

Notes to account is a tool to an investor what stethoscope is to a doctor

Image by Marek Studzinski from Pixabay

 

Notes to accounts are a very important source of information for investors. It elaborates the accounting items like revenue, receivables, inventories, payables, tax, interest-bearing liabilities, contingent liabilities etc.

Woolworths Group Limited (Source: Annual Report 2019)

 

A reader gets to know how the business has reached to the given number. Notes to accounts give a clear picture of accounting policies of the firm and changes to those policies according to the regulators.

Companies provide information such as interest rates of debt, assets and depreciation rates, tax liabilities and assets, elaborated receivables and payables, inventory valuation, impairments to intangible assets.

One can find almost everything in the notes to accounts section of the annual reports. It also allows to cross check numbers with the ones provided earlier by the management in their commentary.

Tax outgo of the business

Johns Lyng Group (Source: Annual Report 2019)

 

Companies pay taxes on profits and it could vary for businesses due to tax benefits and other factors. When similar businesses have highly contradicting figures, readers should check notes and see why there are anomalies.

 

Tax break-up in notes to accounts part of annual report provides extensive information on the tax rates, liabilities, advanced tax paid etc. Readers of the Annual Report get to gauge how the company has treated liabilities like tax disputes where some business book provisions early, and some keep as a contingent liability.

A large amount of contingent liability in the balance sheet of the firm should be compared to the cash levels of the firm and other assets, thereby testing the capability of the business to meet those obligations.

Annual Report- A Steppingstone to star valuation exercise.

Valuation is the ultimate deciding factor when it comes to buying shares of a business. Annual Report provides the investor with all the necessary information to make this decision as important financial and qualitative information are available in the Annual Report.

Revenue is vanity, profit is sanity and cash is reality

This idiom fits appropriately when someone is evaluating annual reports and the business. Cash remains a significant factor in the going concern of the business. A business should have cash to back its profits, but there are many factors that impact the cash conversion of business.

Free cash flow is a widely used metric by investors and interested parties. Cash flow statement of a firm also provides decent insights into the cash utilisation of the business. One should cross check the use of cash like investments, repayment of the debt, dividends, buybacks, borrowings, operating cash flows.

Also read: Dividends and ASX Banks: How the Story has unfolded in long-term for Value Investors

Director remuneration

Afterpay Limited (Source: Annual Report 2019)

 

Annual reports provide detailed information on the remuneration paid to the directors of the business. Management remuneration is checked by most of the Australian retail investors to gauge the corporate governance standards.

It is imperative to check if the management is drawing an appropriate salary and other benefits. Investors do worry when management is taking high fees and not justifying those benefits with the performance of the business.

Incentive plans allow the reader to check the basis of incentives received by the management of the business. Readers get to the goals of the company and management that are linked with incentive plans.

Related party transactions

Mincor Resources NL (Source: Annual Report 2019)

 

This information in annual reports provides with the activity of insiders of the business. These may include forwarding loans to the business by the owners of the business and charging high-interest rates.

In the past, related party transactions have been undertaken by business with people having vested interests in those transactions. It allows the evaluate the management quality of the company.

Insiders could invest in ventures that are personal or procure goods from an entity that belongs to people with vested interests. It could be the case when a company has sold its assets to insiders below the fair value or market value.  

Ownership of the business

Cimic Group Limited (Source: Annual Report 2019)

 

At the end of the annual report, readers get to see who owns the business. Australian companies provide the names of the largest shareholders of the company.

 

Bottom Line

As you have read above, Annual Report is more than just a boring formality that businesses are undertaking. Every serious investor should consider reading multiple annual reports through many numbers of years as well as reports of the competitor companies. It would not be an exaggeration if one were to stick out their neck and say, “An Annual Report a day keeps the loss away”.

PS: All the examples above are for educational purposes only.

 


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