How to Read an Annual Report?

Reading annual reports may seem intimidating to newcomers in the industry. However, with the right guidance and approach, this is a mountain that every aspiring investor and trader can climb. Let’s do it together.

By now, you know that companies publish their annual reports each year and no two annual reports (of different years) of one company are the same. Therefore, it is mandatory for you to go through the annual reports of each year minutely to gain valuable insights about a company based on its past performance and goals.

Let’s recap what is included in an annual report and understand how to read annual reports:

• Balance sheet
• P&L Statement
• Cash flow statements
• Chairman’s communication
• Directors’ report
• Management discussion and analysis
• Auditor’s report
• Notes on accounts and related party transactions

We will now do a deep dive into different sections of an annual report and learn how they throw light onto a company’s overall performance and what they may indicate about the future.

Notice to resolution: This is the section with the proposal to hike the remuneration of the directors. Of course, the Companies Act puts a ceiling on the maximum remuneration that can be paid to directors, over and above which the company has to take the shareholders’ approval. If the remuneration of the management is growing faster than the growth in the income of the company, you may need to be watchful about the integrity of the management towards the company and its shareholders.

Message of company head: The head of a company, be it the chairman, managing director or CEO, uses the annual report as a medium to present their views about the circumstances of the year gone by and what the future holds for the company. They usually discuss broader perspectives, and you have to be careful in interpreting their statements. Also, these statements should not be read in isolation. The factual aspects of the report should be read simultaneously to decipher the message better. You will get better at understanding these messages more clearly with experience.

Here are excerpts from messages from the MDs of a retail company and a paint company. While the first one emphasises cost-cutting to pass through hard times, the second one raises concerns about increasing competition due to new entrants, which may impact not just this company but the entire industry.

Directors’ report & MDA: Directors’ report and Management Discussion and Analysis (MDA) is another important non-financial part of the annual report that may help you find answers to several questions that may crop up while doing financial analysis.

In some cases, companies discuss most of the details pertaining to the economy and industry in the MDA. It is therefore important to go through this report thoroughly to ascertain the opportunities and threats/risks for the business as shown in the above example from the annual report of a building material manufacturing company.

MDA also gives a segment-wise or product-wise performance breakdown, which is very useful in knowing the major contributors to the company’s bottom line. You should also go through annual reports/MDAs of other companies in the same industry to get a clearer picture of the operating environment of the company.

Corporate Governance Report: Though purely non-financial, this report is increasingly becoming important for investors, especially for institutional investors, as it relates to internal practices and policies that lead to effective decision-making and legal compliance. Today, many investors are strict about the ESG (Environmental, Social and Governance) strategy of a company. Such strategies revolve around material sourcing and efficiency, supply chain management, product design and life cycle management, labour practices and energy management. In the long run, a company’s ESG policy will smoothen operations, help attract talent, reduce costs and forge cohesion with the environment.

Here is an excerpt from the corporate governance report of a leading IT company.

It is important for an investor to go through the corporate governance report as it deals with issues such as risk management, internal controls, board balance and directors’ remuneration.

Business responsibility report: Apart from giving basic information about the company, the business responsibility report talks about policies for business responsibility, CSR budget and spending, employee details and measures taken by the company to preserve the environment. Details such as CSR spending and the number of permanent and temporary employees provide valuable clues as to how much the company values the interest of human resources as well as society.

Financial statements: Financial statements are the heart of an annual report and the backbone of financial analysts. They reveal the result of the company’s performance in financial terms, its net worth and its ability to generate funds from operations and other sources. The value of such information increases substantially when we compare such data for several years to ascertain a trend. Computation of various ratios and their analysis and comparison with the past data and of other companies in the sector will help you to conclude whether a company is worthy of investment.

Auditor’s report: Reading the auditor's report for qualifications or adverse comments is necessary as it may have implications on business sustenance. Also, if a company has changed its auditor, it is necessary to verify under what circumstances the change has taken place. If the earlier auditor has left because of management's refusal to share information or other governance issues, it is better to stay away from such a company.

Related party transactions: While these transactions are not banned, if a company has a substantial portion of its transactions covered under this head, it may lead to transparency and governance issues and eventually hamper a company’s reputation.

Points to remember

• It is important to go through every section of an annual report
• Annual reports from the past and those of other companies in the same industry will give a clearer picture of the company’s performance
• Financial and non-financial aspects of annual reports should be read in tandem