How to read annual reports 2

How to read annual reports 2

We are back to our topic here on annual reports. Basically, when you look at a company’s financial statements inside the annual report, sales revenues and profits going up are good signs, and naturally if they go down, that’s bad. But there’s more to it than just that, of course.

More tips and notes here from US investors on reading annual reports (these tips are actually valid all the time, and actually regardless of geographical location; I just got them from US sources):

Read the footnotes; read all the footnotes. The dirty secrets will at least be mentioned in the footnotes. There are many chances for companies to exercise sleight of hand. For instance, a company can extend the number of years of depreciation on major assets (lowering current expenses), hereby resulting in an increase in earnings. This sleight of hand would be revealed in the “summary of significant accounting policies”. Also, for instance, stock options can be expensive for shareholders (mainly through dilution of shares), and not reflected in the earnings. The company must disclose in a footnote what earnings would have been, if options had been factored into the net earnings calculation.

Many believe that the number one figure to look at is the company’s sales in the income statement. This is important. If sales aren’t going up, you need to find out why. If sales are rising, but profit isn’t going up proportionately, look out. The company may be slashing prices out of desperation. If, however, a company’s earnings instead are now going up faster than sales, it might be due to creative accounting. Now really look out!

Take a look at net income to total capital from the balance sheet, called return on capital or ROC. This here is a really good gauge of earnings stability, and would make you a really good fundamental analyst. Operating cash flow is generally considered to be profits before interest, taxes, depreciation, and amortization (such as writing off leased assets) and is called EBITDA. This might be important to you.

You can get a good feel for where the income for the company came from, and where it went, using the statement of cash flow. Not all earnings come from a company’s every day sales. This is key. This statement will show activities such as investments or sales of fixed assets such as a plant.

You can see many things from the balance sheet, for instance, debt is the money that a company owes for long-term financing, either from traditional lenders or from the sale of corporate bonds. Compare debt to total capital (equity). Too much debt is risky, since a slowdown in sales could threaten a company’s ability to pay its obligations. But here, most importantly, you must actually look further to see what the debt has been used for. If the money was used for earnings-producing plant and equipment – that is actually good and poses no reason for concern. If it was used for corporate perks – that is bad and is a red flag.

What are some other things to look for? You can try asking yourself questions about the annual report. For instance, let me cite some here. Is the report well written, clear, concise and succinct? Is it honest and forthright? Are photos inside the annual report modelled/simulated or live? How well do they relate to the text of the report? Do they present an accurate picture? How clear are the company’s product plans? And also, how does the company compare with others in same industry? What else do I need to know? What can I ask? Who do I contact from the company if I have further questions?

You can ask yourself many other similar and related questions. Always ask! Perhaps it is important to also discover more on the Internet regarding how to dissect and analyse annual reports further.