How to Read an Annual Report in 10 Minutes- Part 2

In part one, we laid down the basics. Now let’s talk about numbers.

We are going to take a look at our annual report again. In a good one, we will find a table. Usually, we can find it near the front or back and it will show a five or ten-year financial summary. At the moment, I’m looking at the report for Programmed Maintenance Services, specifically the detailed financial summary going back to the company’s listing in October of 1999. This will give us a quick picture of the company’s financial performance over the long-term.

The first thing we are going to do is compare the company’s trend in revenue to the industry as a whole. We are looking to see whether the industry is cyclical, mature, fast growing or perhaps, on the decline. Having this information will help us put the company’s performance into perspective. For example, is a 10% increase in revenue an excellent increase, on par or is this a indication that the company is under-performing?

Now, what about the trend in profits? Are the profits increasing or decreasing? Are they running in sync with revenue or has its bottom line been growing more rapidly or more sluggishly than the top line? Again, we have to put this in perspective to be able to judge what this means for the company. We should consider whether the company’s costs are variable as they are with Woolworths or Macquarie Bank, or it has high fixed costs like a property trust or Qantas.

Qualified accounts

Next, let’s look at the auditor’s declaration, which we will generally find near the back of the report. If it isn’t there, it will most likely be before the accounts. Usually, we don’t find problems in this area, but we do occasionally find some.

An example of this is the troubled retailer, Strathfield. In their report it says, “The Auditor … [is] considering maintaining the previous audit emphasis of matter as to going concern … and have qualified their opinion on the Cavastowe receivable.” When we see statements like this, we should always pay attention as it is a sign of trouble.

We should also glance at note 1 to the accounts. That will be right after the financial statements. Focus in on the revenue recognition and depreciation calculations policies. Watch for any modifications to the accounting policies that could a tool employed to increase profits. For an example of this, take a look at my review of Telestra ( issue 145/Feb 04)

Let’s get our calculator once again and review the balance sheet. We are now going to look at the debt levels of the business. We want to add the short-term and long-term liabilities (in simple terms, debt), and then subtract the cash balance. What this gives us is the ‘net debt’ amount.

We should be asking whether this number has trended upwards or downwards of the past few years. We want to make sure that we are comparing the most recent figures with a similar point in time in the past. This is especially important for businesses, such as retailers, that are seasonal. Those businesses should be showing a huge spike in cash after Christmas, but a lull right before the holiday.

Keeping it in perspective

A good measure we can use when judging a company is the net debt-to-equity ratio often mentioned in Intelligent Investor. However, it all depends upon factors like the type of industry, its position within the industry and how strong a company’s ability is to generate cash.

Unfortunately, smaller businesses tend to have more debt than conglomerates such as Wesfarmers. The small winemakers are at a significant disadvantage because of this and generally, the little guys are fighting for their lives.

When we look at the debt-to-equity numbers we need to keep in mind that sometimes, it is quoted differently. For example, we are seeing the use of ‘net debt/net debt + equity’ more and more. One reason for this could be that it is always a lower number and never shows up as higher than one. After all, doesn’t that appear less frightening than a net-to-equity ratio that shows up as thousands of per cent?

We can also put things in perspective by comparing the net profit after tax with the free cash flow. No company is worth it if over the long-term, they don’t generate free cash for its shareholders.

Assessing Inventory

Also of importance is a business’ level of inventories, payables and receivables. To avoid marking inventory down, a company may move cash and profit margins around. They do this by holding off on paying its bills (payables), offering discounts to collect invoices early (receivables), or warehousing inventory. We can see an example of this after the sale of Myer. We need to look at the levels of each against the cost of goods sold or sales in order to get a sense of whether they are aligned with periods in the past.

So, we have now reviewed an annual report in 12 steps. It may indeed take you longer than 10 minutes to go through them, but that depends upon the company and sector we are reviewing (banks tend to take longer). However, in the end, we will come out with a solid view of most companies by looking at just the key points of information.