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

It’s annual report season once again and like you, I am waiting for the deluge of reports to arrive in my mailbox. It’s easy to feel as if we are drowning in a sea of paper and numbers, but there is a way to keep our heads above water and minimise the amount of time we spend sorting through all of the information.

So, let’s grab our calculator and pencil and before we get started we should look up the current share price of the company we are interested in. Just go on the internet or today’s newspaper.

Now let’s look at the annual report. The first number we are going to start with is the number of shares on issue. While all of those glossy pictures are engrossing, let’s skip past those and find the accounts. We want to find the balance sheet which, in most cases, is the second statement right after the profit and loss account (the income statement).

Wading through the details

Way down on the balance sheet we will find an “Equity” section. In that section will be a line that says ‘issued capital’ or ‘contributed equity’. There will be a number to the right of the text in the ‘note’ column. Just write that number down. Depending upon the size of the company it should be in the 20’s or 30’s.

Now, what we will find right after these statements are official notes. This is where we will find the details we need. Scan down through these notes and find the note that shows the number of ‘fully paid ordinary shares”.  We want to multiply that number by the share price we looked up before we opened the report.

The number we get by multiplying the share price by the number of fully paid ordinary shares is the stock’s ‘market capitalisation”. That’s the value investors are placing on the company. Having this information will put all of the other numbers we will see in the report into perspective. We can get caught up in figures showing profits and assets worth billions of dollars and knowing the market capitalisation will keep us from getting distracted by these huge numbers.

Who are the owners?

We’re now going to flip all the way to the back  of the report (or close to it)and look at the list of “Top 20 Shareholders”. These are the owners of the company and it can tell us if it is majority-owned by an individual or another company. It can also show whether the ownership has changed since the previous year. We should also see if we recognise any of the names on that list.

Who’s overseeing the company?

At this point we have a good sense of the business’ market value and the owners. We should also know who is overseeing it all. Those individuals minding the store are known as the directors. Right after those lovely shiny pictures and before we reach the financial statements, we will come across the ‘Directors’ Report”. This will show us who the directors are, their experience, qualifications, earnings and degree of share ownership.

Can the board be trusted?

We can learn a great deal by multiplying the current share price by each director’s shareholding and than dividing the result by their annual remuneration (or earnings). What we learn is how many years’ wages the director has at stake in the company. A good benchmark to use is three years.

Scholars of corporate governance will tell us that there is a conflict of interest when there are directors with large shareholdings, but I challenge that theory. The interests of a director should be similar to those of the shareholders and when the director has a large shareholding, it’s actually beneficial to those investors.

For more information, “Trusting the Board” is a special report detailing methods that can help evaluate directors and management.

Let’s now go back to the beginning of the report with all of the colourful photographs and look at the commentary from the chairman and chief executive (some like to be called managing director).

What is the commentary telling us?

Simply reading the commentary in the current report is a difficult way to judge the company’s chairman. Let’s face it, it is not often that everything written is one-hundred percent accurate and genuine.

Instead of reading just this year’s report, we should take a look back at some previous years in a row. This allows us to see whether this executive is consistent in the message they are conveying. We should ask whether they are getting down to specific and measurable objectives or are they making statements that are vague. Are they giving us clear and informative statements or just a bunch of clichés we have heard elsewhere? A great example of a strong and frank commentary is the annual reports of Servcorp. Pay particular attention to their 2002 report when they were struggling for a while.

Remember, annual reports are management’s way of telling us what is going on with their company. If what they are saying is unclear, the likelihood is that it is because management doesn’t want it to be clear to shareholders. While bad management isn’t a sure sign that an investment in the company is bad, I would wonder why anyone would want to start off with a company that can’t be transparent.

Up next in part 2, I will tell you more about the accounts and numbers.

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