5/4/2009
Introduction
Understanding
Annual
Reports
An Annual report is a comprehensive report on a company's
activities throughout the preceding year. Annual reports are
intended to give shareholders and other interested persons
information about the company's activities and financial
performance.
Publicly-traded companies are required to make annual reports
available to shareholders by order of the Securities and
Exchange Commission (SEC).
Annual reports are a critical resource for the casual investor
who is looking to conduct preliminary investment research.
In the post-Sarbanes-Oxley world of corporate America, the
ability to distinguish fact from the hyperbole contained within
annual reports is a crucial skill for any investor.
Finding an Annual Report
To get a hard copy of an annual report, one can visit a
company's web site and contact its Investor Relations (IR)
group.
Usually, the company will mail out annual report to
interested parties free of charge.
However, one can often acquire a digital copy immediately
by downloading it directly from the company’s website.
Sections of an Annual Report
Typically annual reports will include:
•Letter to Shareholders
•Operational Overview (Management Discussion and Analysis)
•Auditor’s Report
•Consolidated Financial Statements:
•Balance sheet
•Statement of retained earnings
•Income statement
•Cash flow statement
•Notes to Consolidated Statements
•Corporate Information:
•Board of Directors
•Officers
•Shareholder Information
Step 1.a: Find the Report of Independent
Registered Public Accounting Firm
Steps to
Reading an
Annual Report
Once you have the annual report, the first thing you should
do is flip toward the back of the report and locate the
section titled “Report of Independent Registered Public
Accounting Firm” or “Auditor’s Report.”
If the annual report does NOT contain this section, throw it
away and avoid investing in the company. A reputable
accounting firm is necessary to prevent Enron-type
investment debacles.
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Step 1.b: Assess the Registered Public
Accounting Firm
Step 2: Letter To Shareholders
Next, make sure the section titled “Report of Independent
Registered Public Accounting Firm” is signed by one of the
"Big Four" firms.
Now that you've established that the annual report was
compiled using Generally Accepted Accounting Principles
(GAAP) - the de facto "Bible" of accounting rules - you
start reading.
Those firms are:
1.
2.
3.
4.
Pricewaterhouse Coopers;
KPMG;
Ernst & Young;
Deloitte & Touche.
The “Letter To Shareholders” section typically provides a
good contextual overview of the company's past, present
and future.
The association of any of these firms with a given annual
report should reassure the reader that proper accounting
practices have been followed in the preparation of the
report.
Step 3: Notes To Consolidated Financial
Statements
The “Notes To Consolidated Financial Statements” is
where a lot of juicy details are placed.
Here you'll find details about critical partnerships,
competitive risks and pending lawsuits. All are critical
factors to consider for the average investor.
Step 5: Consolidated Statements of Financials
The “Consolidated Statements of Financials” section is
where the actual numbers reside and are broken down into
three main parts:
1. Balance Sheet: Static snapshot in time of the company's
financial health. Bear in mind that this document has
changed since published in the annual report.
2. Cash Flow: Shows the money flows in and out of the
company.
3. Profit/Loss: In accounting class we think of this as the
Income Statement. This is a critical section that shows
whether or not the company is making more than it’s
spending.
Step 4: Management's Discussion And Analysis
At this point, it's usually a good idea to review the section
titled “Management's Discussion And Analysis.”
This is where a lot of company's place their spin, puffery
and other syrupy content - (usually written by public
relations folks such as me) to position the previous year in
as positive a light at possible. There's good information
here, but it’s best to read it with a dash of scepticism.
Step 6: Analysis of Consolidated Statements of
Financials
Horizontal Financial Statement Analysis: This technique is also known as
comparative analysis. It is conducted by setting consecutive balance sheet,
income statement or statement of cash flow side-by-side and reviewing
changes in individual categories on a year-to-year or multiyear basis. The
most important item revealed by comparative financial statement analysis is
trend.
A comparison of statements over several years reveals direction, speed and
extent of a trend(s). The horizontal financial statements analysis is done by
restating amount of each item or group of items as a percentage.
Such percentages are calculated by selecting a base year and assign a weight
of 100 to the amount of each item in the base year statement. Thereafter, the
amounts of similar items or groups of items in prior or subsequent financial
statements are expressed as a percentage of the base year amount. The
resulting figures are called index numbers or trend ratios.
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Questions that could be
asked:
•Why is there an
increase in the stock of
the company? Has the
company changed its
inventory policy?
•Why did taxation
increase so tremendously? Were there any
changes in taxation? Is it
reflected by the increase
in sales? Profit?
Step 6: Analysis of Consolidated Statements of
Financials
Vertical/Cross-Sectional/Common Size Analysis Techniques:
Vertical/Cross-sectional/Common size statements came from the problems
in comparing the financial statements of firms that differ in size.
In the balance sheet, for example, the assets as well as the liabilities and
equity are each expressed as a 100% and each item in these categories is
expressed as a percentage of the respective totals.
In the common size income statement, “sales” (aka “turnover”) is expressed
as 100% and every item in the income statement is expressed as a
percentage of Sales.
•Why is there an increase in the fixed assets
and at the same time
decrease in the longterm debt? How were
these assets financed?
Questions that could be
asked:
Why is more stock
being carried?
Why is the value of the
current assets
increasing?
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