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18 November 2019

How to read a company annual report

Every year any company that has issued shares to retail investors must prepare and publish an annual report.

  • Annual reports help show how a company has been performing.
  • They give you an opportunity to evaluate the company’s leadership team, help you check whether your existing investment is performing to your expectations and enable you to make informed voting decisions at the annual general meeting.
  • Annual reports can also be used when you are considering investing in a company in the first place.
  • Since annual reports generally follow a standard order, it can be straightforward to review them once you are used to knowing what to look for.

In particular, there are some key things to think about when trying to understand the company’s financial performance.

 

Four things to think about when reading the commentary

Annual reports typically start with a commentary from the Chief Executive and the Chair. Here’s what to think about as you read these sections.

The aim is for the company to provide a complete picture. Although directors and management can face action for making misleading statements, their reports may not fully discuss any negatives affecting performance. For example, is that ‘one-off’ event or transaction really a one-off? Is reference to ’solid’ performance really covering poor performance?

Has the company delivered on what they said they would do in their initial offer document, earnings projections or previous annual reports? If there are large differences, or changes to the measures being presented, are the reasons adequately explained?

What evidence can you see of the difference management is making to the company. After all, it’s easier to grow sales in a booming economy with limited competition. Do you understand the industry and the company’s competition to be able to assess how sound management’s decisions have been. Does the commentary explain the impact of their decisions on the financial performance?

Most companies report on their performance using a mix of financial measures. Some are generally-accepted accounting practices (known as GAAP), like ‘net profit after tax’ and have been audited. Other measures, known as non-GAAP, can be unique and company specific, such as ‘underlying profit’ or ‘adjusted EBITDA’.

Four things to think about when reading the financial statements

The financial statements section includes:

  1. Income statement. This shows revenue, expenses and net profit. Statement of financial performance or profit and loss statement are other names for an income statement.
  2. Statement of financial position. This outlines the company’s assets and liabilities, net assets and equity. You might also see this called a balance sheet.
  3. Statement of cash flows. This shows you the actual cash which comes from the company’s operating, investing and financing activities.
  4. Accompanying notes explaining the significant accounting policies, balances and transactions.

Here’s what to think about when reading this information

Accounting isn’t a science – companies make judgments when preparing financial statements. Look at the significant accounting estimates and judgments within the notes. This will indicate the most complex decisions made by the company in preparing the financial statements. The auditor’s report will also document ‘key audit matters’ (what the auditor deemed most complex). Then take a look at the specific notes explaining these matters further to make sure you understand them.

Revenue growth is noteverything. Some start-up companies have great growth in revenue; other established companies may produce consistent revenues annually.  In the income statement, look at the net profit after tax line and its relation to revenue year on year. Look at the types of expenses and whether these are increasing more than revenue. Is revenue driving profits or is it at an increasing cost resulting in losses?  This can be a deliberate and successful strategy in the long-term if the company has plenty of funding or cash. If loss making, do you understand how and when the company intends to return a profit?

If you are looking for a steady income stream, you want to know your dividend payments are sustainable and in line with the company’s dividend policy. Is the company generating sufficient cash flows from operations and after investing activities to pay its interest and dividends? Are they borrowing or using cash reserves to pay dividends? If so, the payment of dividends may not be sustainable.

A company may produce profits but check the statement of cash flows.  Reading the statement should enable you to answer the following questions: how healthy are operating cash flow balances in relation to revenues? How is the business financed? Is cash being invested for growth? Are cash reserves depleting annually?

Red flags to look out for

There are certain ‘red flag’ words or phrases you can look for that may indicate all is not well with a company or parts of its business.

Companies should state whether there are events or conditions that cast significant doubt on its ability to continue operating normally. Where this uncertainty does exist and the financial statements have been prepared as if the company will continue, this matter should also feature in the auditor’s report.

If current liabilities are greater than current assets in the statement of financial position it could be a sign the company is in trouble, regardless of how profitable a company looks. If it expects to generate strong operating cash flows in the next year, or has financing arrangements, this may not be a problem. If the company is in this position has it explained its plans and do they seem feasible?

Related parties aren’t independent of the company so look at whether or not any transactions between them have been carried out at market rates (referred to as an ‘arms-length’ basis). Favourable rates can distort a company’s financial performance. Is it possible the company is profitable because it is being supported by related parties? Or is this company supporting other related parties that are not performing?

Look for other terms like ‘breach’, ‘dispute’, ‘litigation’, ‘covenant’, ‘bad debts’ ‘impaired’  ‘impairment’ or ‘write off’ (you can do this easily by reading an annual report online and using PDF search tools). Notes containing these words may highlight risks in the business.

A ‘qualified’, ‘adverse’ or ‘disclaimer of opinion’ indicates significant issues cropped up during the audit. Read the auditor’s comments carefully to find out why. Remember an audit isn’t a guarantee. It simply provides an independent opinion on whether the financial statements are not ‘materially misstated’.