An annual report can give us valuable information if we know what we are looking for. However, let’s face it, hundreds of pages with figures and financial jargon everywhere we look can be intimidating.
So, where do we begin? Well, the first thing we should determine is our goal. Always look at an annual report with the idea of what we are trying to achieve in the forefront.
1. Understand what the company does
When we examine a company for the first time, ignore the income statement and balance sheet for the moment and go straight to the company’s website. We first want to learn what the company does. You can find this information if you go to the ‘operating segments’ section.
That will give you a quick breakdown of each division. We can stare at balance sheets for as long as we like, but until we have a basic understanding of how the company makes its money, the numbers on the page have very little meaning. We will know we understand the company when we are able to explain it to a 10-year old.
Once we are convinced that our hypothetical 10-year old understands the company, we have passed the ‘simple business test’. Now it’s time to see how well the company is doing.
2. Understand the company’s profit margins and competitive advantages
Before we delve into the report, we will want to know what we are expecting to see. So, if we have an infrastructure asset that we are expecting to result in stable and recurring income, but it doesn’t, we should be inquiring as to why the company isn’t as stable as we thought it would be.
If we see a manufacturing company with margins above 20%, we should be asking what is it about the product that makes customers willing to pay a steep price. We can often uncover competitive advantages when looking at unusual or unexpected returns on capital and margins.
3. Look at the 2 essential numbers
Now we can get down to the actual report. What are the most important numbers to which we should pay attention? Depending upon the industry, looking at similar ratios and numbers can have different meanings and that makes it difficult to come up with a hard and fast rule.
No matter what the industry, there are two types of numbers in particular that we should be looking at in an annual report.
The first numbers are the borrowings on the balance sheet. Sometimes they show up on reports with a different name such as, “interest-bearing liabilities”. We may also see them divided by “current liabilities”, meaning they are due within a year and long term. We can figure out the ‘net debt’ of a company by deducting the cash a company holds in current assets and assume that the cash will be used to pay back the debt.
However, if we find that the ‘net debt’ is large in relation to the business’ net assets, or shareholders’ equity, we should proceed with caution. If we come across a company with a net debt-to-equity ratio over 50% or interest coverage ratios below 5.0, there is a good chance that the business will take a hard hit when a crisis happens. In other words, we should look for a company with as little debt as possible.
The second piece of information we need to understand is whether profits are being converted to cash. Cash can in turn be used to grow the company or be used for distribution to shareholders as dividends and share buybacks. A warning light should go on if we see free cash flow regularly lagging behind net profit. This could signal that the company is capital-intensive and low-quality.
I would suggest not only looking at the current annual report, but also downloading the annual report from a few years ago. Compare it to the current report and ask whether the debt is rising or falling and whether the margins are getting wider or diminishing. By looking at the company over time, we can get the best possible sense of where it will be heading 5 or 10 years down the road. To get a picture of a company’s 5-year history, go to their website and click on the ‘financial data’ link.
4. Will Management Act In Your Best Interests?
Regardless of which company we are researching or how impressive their numbers, the ultimate question we should be asking is whether management will act in our best interests.
A good indicator of a company that will act in our best interests are those that have a high level of directors’ ownership which can be found under the ‘director interests’ and ‘key management personnel disclosures’ headings. Another measure to pay attention to is executive compensation based on earnings per share growth, rather than net profit.
We should also look for language that seems to be overly promotional when reading the annual report. This type of language could be an attempt to distract and mislead us from other things.
An example of this is Unilife. The reason this company was called out had nothing to do with numbers that didn’t add up. It had to do with the language used in the report. Ears began to perk up when their annual report boasted that their company offered an ‘exponential growth opportunity’ and had the phrase, ‘you can’t make this stuff up’. Those are red flags we should not ignore. In fact, allegations were made that the management of Unilife had fudged their numbers and that led to more than a 90% drop in their stock.
Just remember that reading an annual report should not be a passive activity like reading a book. We should dig deep, check the numbers and ask questions as we work our way through it. Think of questions you would want to have answered if you owned the company and had a manager running it for you.