Primary source of information
Annual report is the primary source of information of a company; it provides information on most of the business activities and financials that is required by an investor in making decisions. Companies disclose the annual reports end of every financial year.
Annual reports contains information that can be daunting for the first look, but knowing how to sift the information and separate what information is required makes it easy to extract the required information from an annual report. We are going to make reading an annual report more simple and a easy task.
Why annual reports?
An investor should clearly define the purpose for reading an annual report Investors look to find out how the business has been performing in the current year, and managements outlook of the future. Managements clearly give an outlay of the current business activities, the future outlays and projections of the business, also annual reports contains information and financial statements of a company.
2 stages in reading an annual report
1. Inspectional or skimming
2. Analytical or the deep dive
Inspectional stage - In the inspectional or skimming stage an investor is looking to find out basic information of the company and its business activities, at this stage the investor is not interested to deeply read the annual report but just to know its principle business activities.Time spent in this stage could be less than 1 hr on a company.
How to read or Skim an annual report
At this stage all I am interested is to find out basic information of the company. I have not yet made up my mind to invest in the company. I want to know if its investment worthy or do I understand the business.
1. I want to know what the principle business activity of the company is. All companies provide annexures in which they mention their activities, which gets right to the companies principle business activity (see below screenshot)
The above screen shot shows the turnover of the company - ELGI - 100% compressors. So now I have a basic idea of the business the company is doing. Now I need to get oriented with the type of products, manufacturing capacity and other details. So I go the next step in skimming an annual report.
2. Management discussion and analysis - (MDA) This section covers the business activities, broadly covers the general business climate, the world GDP, economical activities etc. (Which can be omitted for most part).
The company talks about the performance, outlook in general and about the future plans of the company. Reading this section gives the understanding of the business and what the management is anticipating. By the end of the section we would now have a fair knowledge about the business, type of products, geographical areas, exports and imports of the company, revenue share of the company categorized by products and region etc.
In MDA most companies tell about their business models, which are an important part of understanding the business, if they are not explicitly stated it’s the duty of the investor to find out the business model.
There is one caveat - Managements usually are persuasive in “framing words” which looks promising and future oriented, there are many companies that provide annual reports that look fantastic and fancy. This is another way to lull you. Don’t fall for the Ulysses song. Most management outsources their annual reports to look attractive with key jargon like " We have achieved a very high ROCE", "Our vision is to be a billion dollar company in 5 years" etc . AN investor needs to use his critical thinking skills to filter out the real facts and not fall prey for these information. Not every report will look like a Berkshire Hathaway report filled with wisdom.
At this stage I am reading to get basic information and not to make up my mind to invest. So going deep into other matters is a waste of time.
There is another step you can take in inspectional reading - Look into the website of the company and find out its products, latest launches and recent updates to get more specific
details. The company’s website may cover more recent updates which would be helpful if you’re reading an old annual report.
After this stage i should be able to reasonably answer a few basic questions about the company and its products. This level of reading is preliminary and just orienting with the business I. Only after which i can now take a deep dive to study further.
1. Do I understand the business? If no there are no further questions required. We can look for other companies, If i don’t understand a company it’s not worth spending time . There are companies which I can understand reasonably well.
2. Is the company within my circle of competence? If yes than I know I can reasonably estimate the future economics of the business.
Stage 2 - Analytical reading - At this stage the investor takes a deep dive with a motive of understanding the business on a deeper level. This stage requires more time and energy in the form of more active reading. Most investors read 10-20 years of annual reports in this stage.
To reach these stages in reading an annual report, the investor must be convinced of the business and should reasonably understand it. Without understanding the business of the company this stage is total waste of time.
This stage requires the repetition of all the above steps in the inspectional or skimming stage. Now let’s dive deep into the next stage of reading annual reports.
1. 20 Years of Annual reports - At this stage I am looking to understand the business at a deeper level, so I would like to know how the company has evolved in different phases of the economy, In 20 years the business would have gone through different interest rate phases, different government policies, different world and economical events. So I would like to know how the management has shaped the business.
All these information will be available in the MDA section of the annual report. I am just reading from 20 years back to look at it from an evolutionary lens.
As I read I take down notes on important phases like,
How has the company coped up with the 2008 financial crisis?
How did the management mobilize funds in different interest rates period?
Has the company shut down any loss making units?
Has the company delivered on a promised capex or delivered a project in time?
Has the company’s management kept up with its words in closing down debt?
As I read through 20 years of report, there are many phases in the life of the company where there is information that you can extract from an annual report and which is crucial to your decision making.
Note: If the company doesn’t have a 20 year history or if it’s a new startup company, look at its DHRP to find out more details on the company. The company’s website contains most of the annual reports or can be found in BSE website.
2. Directors / Chairman’s message - In analytical reading we need to take a dive into what the chairman has to say about the performance of the company. Most management paints a rosy picture and defends their performance be it good or bad; rarely do managements accept any fault or admit the truth of their shortcomings. For an investor seeking truth is as important as having a different perspective, so I would rather look out for the truth in the facts and figures than going by the managements words.
3. Management and team - The management team is very important to understand how a business has evolved throughout the years and how it is going to evolve in the next 10-20 years, Information is available in the annexure section. This section needs more detailed study, let’s dive further deep into the management section.
Board members - Board of directors, Independent directors, Non-executive directors. This section provides the information on the full governing board of the company. In this section I would particularly see a few key insights - How are the board members connected to the CEO or Chairman of the company, Do they have any relatives on the board? What’s the past record of the CEO in other companies? Did any of the management team face any litigation charge? (This requires a background check on the promoters current and past)
Remuneration - This section of the AR covers the annual pay allowances to the management. There is a ceiling as per norms on the pay allowances; I would like to see if there are any discrepancies and what % of net profits is drawn as salary. How is the company increasing or decreasing the pay each year in line with the performance of the company. ESOP’S (Employee stock option scheme) requires attention as most companies reward their employees with stock options that can be vested in a future date. Overall for a shareholder there will be dilution of equity by ESOP’s.
Share-holding pattern of promoters - This section is the most crucial in an AR in analyzing a management, how much Skin in the game does the management have in the company? I would like to know management / CEO / Chairman’s shareholding % in the company this reveals some key insights in the motives behind the development of the company.
Also I would like to see if there are increase/ decrease in the shareholding of the promoters, Are there any share transfers to related party companies? Is the management holding shares in a different name?
Shareholding pattern - This section contains the shareholding pattern of promoters, FII, mutual funds, FDI, Corporates, Individual shareholders holding > 1% of the company’s shares and retail. The inference from this section is to know the structure of the shareholding and the investor should develop his own perspective here based on the facts. Ex: Companies with high promoter holding and high FII holding reveals an already identified company, Low promoter shareholding may reveal the managements reluctance to grow the company vs. the one where promoters have a motivation to grow the company. It should be viewed relatively and not on an absolute basis.
Related party transactions - Another important section, the transactions carried out by the management with its related parties, related parties may be relatives, sister concern, subsidiaries, or companies of board members. There can be incentive mismatches in doing such transactions. Companies can give favorable terms to related parties in sale/purchase of raw materials or products or loans that may affect the shareholders. Any high amounts of receivables in terms of loans or sale transactions will need a closer scrutiny.
4. Financials - This section of the AR is the Financials of the company. Heart of any business is the balance sheet. This section in the analytical reading requires most attention. I would spend major part of the time in this section to understand how the business has evolved in last 20 years; does the business have the balance sheet to attract opportunities in the future? Can the business sustain without raising capital? Are the cash flows enough to sustain for a long period of time etc.?
1. Balance sheet - Standalone and Consolidated
2. Profit and loss statement
3. Cash flow statement
For a 20 years trend in the balance sheet or cash flows we can refer to websites like Morningstar, Screener.in or Stock edge which covers 10-20 years of financial data. Financial statements are given for yearly basis in AR’s. However we will not dwell into how to analyze these statements. Financial statements help you to analyze the Value of the business. As fundamental investors we are least bothered about the other styles like technical analysis. The value of a business is different from price and we derive it from the financials.
(Watch out for a separate post on ratio analysis for investors)
5. Subsidiaries - If there are subsidiaries, Step down subsidiaries, we should have a look into these companies. Most companies may have a loss /profit making subsidiary and the cash flow for which may flow from the parent company.
6. Foot notes - This is another important part where most investors omit. Foot notes as we say “Devil is in the details” do have some crucial information of the company. Foot notes contain the elaboration on the financials of the company.
We miss the main details if we stop only at the Balance sheet, Cash flow & P&L statements. Many crucial financial details are included in the foot notes.
Ex: I invested in a Company called TARA JEWELS, in the foot notes the company disclosed huge “Contingent liabilities” (which may arise in the future but not yet realized in the profit and loss statement) which was higher than the current debt on books. That warranted a closer study and I exited the company.
Why I am emphasizing on foot notes is that there are granular details that are not discussed explicitly in the financial statements, but which can have a material impact on the business.
7. Other items to watch out in the Foot notes
Hedging policy of the company
Employee pension scheme and unfunded liabilities
Details of foreign subsidiaries and litigations on them which may / may not have a material impact
Amortization
Contingent liabilities
Tax disputes and other litigations
Public lawsuits
8. Auditors Report - This section of the AR contains the approval of auditors of a company’s accounting policies and information provided by management. This needs to be read closely as certain auditors do not sign or show their contradictions with the management’s data.
When there is a contradiction and discrepancy with management’s data with that of auditors they raise concerns which should give the investor a warning sign to dig deeper into the issue. However these need to be monitored on a regular basis via quarterly reports and communication from the management.
I would also see if there is a frequent change in auditors which is another concern to take a deeper look into the reasons or motivations of the management behind such changes.
We have reached the final stage of analytical reading of the AR. By now an investor reading the 20 years of reports in a deep sense should have gained an understanding of how the company has evolved. After this stage an investor follows his research through other methods and finally reaches the valuations by his own methodology.
Field research
Interaction with other investors
Research reports from other services
Valuations methodology suited for the investor
Annual reports cover most part of the research and covers major details. However they are not an end in itself. An investor looking for more in-depth analysis like we do on our research projects can look for further sources like blog posts, paid broker reports and other sources of reliable data to deep dive further.
There are many styles with which one can approach an annual report, the style outlined here are what we follow at CAPRICH INVESTMENTS. There are no hard and fast rules in reading an annual report, the system outlined here is a systematic view of how we do it, you can follow any methodology you like which benefits your research and aids to extract more information.
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