Tuesday, March 23, 2010

How and What to Look into Annual Reports

How  to Look into Annual Reports?

The thought of poring over annual reports to glean information about a company or its growth prospects may seem terribly dull to most new investors.

Nevertheless, the annual report remains the most authentic source of information about a company and contains important facts about its financial condition, growth strategy and current challenges that are not readily available upon an Internet search. A well-written report can give you a rare glimpse into the management's outlook for the industry or its views on new trends in the market. So for those who do not know (or remember) what an annual report looks like, here is a quick guide to reading this document.

The manner of presentation differs from one annual report to the other; some are mini opuses that promise to be a one-stop guide to the industry and company, others barely make the cut when it comes to providing crucial information. Most reports, though, will have the following important components:

The director's report, which will detail the company's operational performance in the year gone by.

Management Discussion and Analysis, where the management provides an outlook on the industry, competitive scenario, new challenges and risk factors and outlines its future strategy.

Detailed financial statements of the company and its subsidiaries, as well as consolidated financials, along with the auditor's report.

The basics, for starters

You may also find pictures of happy employees participating in corporate events. Heart warming, but we suggest that you skim through all that gloss and start with the director's report. This will give you an overview of the co mpany's performance across various segments and an idea of the factors that drove performance.

If you are unfamiliar with the industry the company operates in, then the Management Discussion and Analysis (MDA) is the best place to begin. Clueless about the pig iron industry? Read the Tata Metaliks report for data on the globa l pig iron and foundry market and pig iron price trends. The report also includes an interview with Tata Metaliks' management, which discusses some of the key events that took place during the previous year and its perception about the competitive scenario.

Companies put forth their views on a variety of topics that concern their industry, be it Government regulation, consumer or user industry trends or changes in the global picture in the MDA. They then articulate their own plans to capitalise on unfolding opportunities.

Between the director's report and MDA, you will get a fairly good idea of the businesses the company operates in, its key focus areas, the challenges ahead and the measures it has in place to improve financial performance in the year ahead.

For number-crunchers

For those who believe that it is numbers that do all the talking, the financial statements in the annual report provide you with details that you are unlikely to find on the BSE or NSE Web sites. For instance, you can figure out the extent to which a company is able to fund its expansion plans on the strength of its current operations by looking at its cash flow statements.

The schedules to accounts provide break-ups of income, expenditure and other items. For instance, you may want to know what components constitute "other income", particularly if it has been a significant contributor to profits that year. The item-wise split-up of the components classified under other income will help you decipher how much of the non-operational income is recurring in nature. You are also provided with segmental information — both geographic and business.

Similarly, schedules elaborate on balance sheet items such as long-term and short-term loans. For retailing companies, for instance, inventory management is crucial and you may have to compare the inventory positions over a three-year period to understand how efficiently the retailer manages its stores. Or for cash-rich companies, the quality of their investment book may well play a role in valuations.

The annual report also discloses the financial information of the company's subsidiaries, besides providing financials on a consolidated basis.

As new, high-growth ventures are typically routed through subsidiaries, companies are beginning to command valuations based on their consolidated numbers.

Be sure to look at the notes to accounts to understand the accounting treatment of various revenue and expenditure items. Those who are unfamiliar with accounting practices can make-do with looking for changes in accounting policies . This might tip you off on the impact of one-time earnings or expenses.

Also look for the auditor's qualifications to accounts for any assumptions that have been made while preparing or auditing accounts.

Nooks and corners

The annual report also contains little nuggets of information that could provide you with additional insight into the company.

Management background: For instance, you can find brief profiles about the directors on the board of the company. The presence of directors with strong industry standing lends credibility to the management of the company.

The shareholding pattern of the company will reveal the extent of promoter holding and the extent of institutional interest in the company.

Production and utilisation figures: For manufacturing concerns, the production figures assume significance. The production as a proportion of installed capacity (utilisation) could give you an idea of the efficiency at which the compan y is operating and the headroom for further volume growth. This information is particularly pertinent if the company is planning further expansion.

IPO proceeds utilisation: For newly listed companies, the progress on the expansion plans that had been outlined in the offer document and the utilisation of the IPO proceeds are also disclosed in the annual report.

Notices to resolutions: Some special resolutions passed at the annual board meeting also merit attention. For instance, resolutions passed to increase borrowing limits are cues to the company's desire to leverage its balance shee t.

Explanations are also available on why the resolution has been mooted. For example, Colgate Palmolive India's latest annual report explains the reasons for its declaration of a special dividend and a capital reduction.

This list is far from exhaustive. Going through all this might mean a lot of time and work. But it does make your information more authentic than the tip from your broker friend or the analyst on TV.

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