Everyone in the financial market knows that if you want to understand about a company, most of the essential information you need are embedded in the annual report.
It is very important to know the information you can get out of it and the information you can’t. Only then will you be able to know what you should be looking out for in an annual report.
Many investors are very messy in the way they analyze. While this may work for some, having no structure in investing may suggest that the individual is lost. Having no structure also leads to a greater likelihood of committing errors too as there is no system to fall back on.
In this article, we will be highlighting how you should read an annual report and what you should be looking out for.
Letter to shareholders
This is the part where many investors skip because all CEOs will delegate this task to their underlings to write. They are all fluff and flowery languages anyway, right?
Yes, for most cases. Therefore, candid and self-written letters suggest that the CEO may care more than others about the company. For instance, Warren Buffett of Berkshire Hathaway has never failed to write his letters to shareholders himself every single year. While sweeping, this may give the management some points.
Industry & Financial performance remarks
“Our company’s earnings have fallen by xx% due to unexpected and nonrecurring reasons such as… We expect earnings to bounce back next quarter and cash flow to turn positive.”
A preliminary analysis of the above statement may suggest that the management is in self-denial. If the company has been doing poorly and the management still believes that investors will take their word for it then perhaps you ought to question about what else they may be hiding.
Apart from your basic duty of understanding the business and the industry, you should be looking out for how the management is responding to the economic environment.
Is the management myopic? Does the management readily admit the company’s weaknesses, or do they seem to be covering things up?
In good times, is the management excessively exuberant about the future? Do they seem to abandon all form of risks control and expand furiously?
Answering all these questions should provide you a pretty good idea of whether the management’s interests are aligned with shareholders’.
The technical aspects of reading financial statement should not be too demanding. Understanding accounting lingo and how accountants put in the numbers will provide you with the basic tools to interpret financial statements.
The slightly more difficult part comes where you have the duty to adjust the numbers and interpret them from a value investing lens. Through understanding the way the management accounts their numbers, it reveals how much transparency there is in the management too.
Does it seem like the company is inflating its earnings where cash flow remains negative for long periods of time? Are depreciation and amortization charges very low relative to the capital expenditure? Is it frequent that the company revalue its long-term assets to reflect gains?
You should never attempt to interpret the numbers on its own. Read it after understanding the story behind the numbers so that you can have the bigger picture.
Here, we shared with you three major parts of the annual report you should be taking note of. Many investors skim through most of the report and go straight to the numbers, we beg to differ. There are still nuggets of information lying around that shows a lot about the company.
In the next article, we will be touching on how you should read the annual report!