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Chapter 1.7: All you need to know about the annual report
Corporate earnings announcements and annual reports are a must as per law. This is to keep investors informed about the company’s operations and financial performance. In this section, we will learn about these reports, how to understand them and why they are important to the investor.
WHAT ARE COMPANY EARNINGS?
Companies undertake activities that produce a good or service. This is sold to customers who pay a certain amount of money for it. The total amount the company receives is called 'revenue'. A company also incurs expenses on employees, utility bills, costs of production and other operating expenses.
Once you deduct these expenses, the surplus left is the company’s earnings, or net profit. Usually, income earned from operations is the key source of profits. Many companies also earn additional income from different kinds of investments.
Investments generate income for businesses by way of either interest on loans, dividends from other businesses, or gains on the sale of investment property.
Thus, company earnings are the sum of income from sales or investment left after the company has met its obligations.
WHAT ARE QUARTERLY AND OTHER FINANCIAL REPORTS?
Every three months, every company has to submit details about its financial performance. These are called quarterly reports. In addition, companies may also provide with special reports called statistical supplements. These provide investors with additional financial information. These, however, are not as comprehensive as the annual report.
Thus, quarterly reports are very similar to the annual reports, except they are issued every three months and are less comprehensive. These are filed with the stock exchange, which then makes it available to investors.
WHY ARE EARNINGS IMPORTANT TO YOU AS AN INVESTOR?
As an investor who holds shares of the company, you have part ownership of the company. You are thus entitled to get a portion of the company's profit as dividends. Until you sell the stock, this is your primary source of income as an investor from the stock holding. As a result, if the company does well and earns more profit, you receive more as dividend. Not just that, it will also drive up the inherent value of your shareholding. This means you earn more returns.
Sometimes, when a company is in the initial stages of growth, it may choose to reinvest its earnings for operations and expansion. While you are temporarily at a loss as an investor, this increases the likelihood that you will get higher dividends in the future.
Company earnings are important to you, even if you hold its bonds. This is because, when you lend money to the company by investing in its bonds, the company uses part of its earnings to repay you through interest payments. The greater the company’s earnings, the more secure you can be that you will receive your interest payments. So, company earnings are important to you because you make money when the business you invest in makes money.
INSIDE THE ANNUAL REPORT:
Here is what comprises an annual report:
- A letter from the chairman on the high points of business in the past year with predictions for the next year.
- The company philosophy – a section that describes the principles and ethics that govern a company's business.
- An extensive report on each section of operations within the company, describing the company's services or the products.
- Financial information that includes the profit and loss (P&L) statements, cash flow statement and a balance sheet. Depending on its income and expenses, the company will either make profits or show losses for the year. The cash flow statement, as the name suggests, reflects where the money came from and how it was utilized. It is an important financial statement as it helps one understand if the company is generating enough money from its operations to fund the costs, or if the company is constantly reliant on external funding like debt or equity. The balance sheet describes assets and liabilities and compares them to the previous year. The footnotes will also give you reveal important information, as they discuss current or pending lawsuits or government regulations that may impact the company operations.
- An auditor's letter in the annual report confirms that the information provided in the report is accurate and has been certified by independent accountants.
- The annual report also includes a section called management’s commentary. In this section, the management explains how the balance sheet and income statements have been prepared, where the funds have come from, and how they have been utilized. This is also an important section as it reflects the management’s mindset and outlook
UNDERSTANDING THE BALANCE SHEET
The balance sheet is one of the most important financial statements of a company. The logic behind producing a balance sheet is to ensure that all of the company’s funds are accounted for, and that financial accounts are always in balance. It is reported to investors at least once a year. You may also receive quarterly, semi-annually or monthly balance sheets. The contents of a balance sheet include what the company owns, what it owes, and the value of the business to its stockholders.
Let’s look at these three components in detail:
What are Assets?
This is the component that details all that the company owns. Assets, then, are any items of economic value owned by a corporation that can be converted into cash. There are two main kinds of assets – current and long-term assets.
Are assets that can be easily converted to cash in the short term within one year. Bondholders and other creditors closely monitor a firm's current assets since interest payments are generally made from current assets. It is also important because assets can be easily liquidated into cash, which could help prevent loss of your investments incase of bankruptcy.
Also, current assets are important to most companies, as they are a source of funds for day-to-day operations. It is, thus, evident that the more current assets a company owns, the better it is performing.
- Cash and cash equivalents are also a kind of current assets. Cash equivalents are non-cash items, but which can be converted into cash quite easily. For this reason, they are considered equal to cash. Cash equivalents are generally highly liquid, can be sold easily, short-term and safe investments like bank deposits.
- Accounts Receivable is another kind of a current asset. It is the money customers – either individuals or corporations – owe the firm in exchange for goods or services that have been delivered or used. For example, suppose your shopkeeper is willing to supply goods on an account-basis, and you pay for all the goods at the end of the month, whatever money you owe him will be counted as accounts receivable until you actually pay for it.
Simply put, this is business being done on credit instead of cash. For this reason, it is a significant component of the balance sheet. Although accounts receivable is money owed to you, it is recorded as an asset on the balance sheet as it represents a legal obligation for the customer to pay the cash.
- A firm’s inventory is the stock of goods produced that have not been sold yet. It sometimes also includes the materials already bought for manufacturing a particular good.
For this reason, a manufacturing company will often have three different types of inventory: raw materials, works-in-process, and finished goods. A retail firm's inventory, generally, will consist only of products purchased that are still to be sold. Since inventory is likely to earn the company money in the future, it is recorded as an asset on the balance sheet.
Long-term assets :
Are those assets that cannot be converted into cash in the current or upcoming fiscal year.
They are grouped into several categories like:
- A long-term tangible asset is one that is held for business use and is not expected to be converted to cash in the current or upcoming fiscal year. Examples include manufacturing equipment, real estate, and furniture. Fixed assets like equipment, buildings, production plants and property are a kind of long-term tangible asset. They are very important to a company because they represent long-term investments that will not be liquidated soon and can facilitate the company’s earnings.
On the balance sheet, these are valued at their cost. As the value of the asset declines over the years, depreciation is subtracted from all such assets, except land. Depreciation gives you an estimate of the decrease in the value of an asset that is caused by 'wear and tear'. Sometimes, it also occurs because the asset has become obsolete. Depreciation appears in the balance sheet as a deduction from the original value of the fixed assets. This is because the value of the fixed asset decreases due to ‘wear and tear’.
- Intangible assets are non-physical assets such as copyrights, franchises and patents. Since they are intangible and not concrete like tangible assets, it becomes difficult to estimate their value. Often there is no ready market for them. However, there are times when an intangible asset can be the most valuable asset that a company possesses.
What are Liabilities?
This is the component of the balance that deals with a company's debt to outside parties. They represent the rights of others to expect money or services of the company. A company that has too many liabilities may be in danger of going bankrupt. Examples of liabilities include bank loans, debts to suppliers and debts to its employees. On the balance sheet, liabilities are generally broken down into current liabilities and long-term liabilities.
Current liabilities :
Are debts that are due within one year. They include the money owed for taxes, salaries, interest, accounts payable and notes payable. A company is considered to have good financial strength when current assets exceed current liabilities.
- Accounts payable is the amount the company owes to suppliers that it has bought raw materials and other goods from. You will often see accounts payable on most balance sheets. Let us take the example used earlier for accounts receivable. When you purchase goods from the shopkeeper on a monthly-account basis, whatever money you owe him before the end of the month is counted as ‘accounts payable’ in your balance sheet. Since the money is paid over a short-term, accounts payable is counted as a current liability.
Long-Term liabilities :
Are long-term loans that are to be paid back over a period greater than one year. These debts are often paid in installments. If this is the case, the portion to be paid off in the current year is considered a current liability.
What is Shareholder's Equity?
This is the value of a business to its owners after all of its obligations have been met. Shareholder’s equity is calculated as the value of a company's assets subtracted from the value of its total liabilities. Shareholders' equity is also calculated by the sum of the amount of capital the owners invested, and the portion of the profits that the company reinvests rather than distributing as dividend.
Recollect that companies distribute a portion of their income as dividends to shareholders. Whatever left is called retained earnings. This is reinvested in the company for its operations. Thus, shareholder’s equity reflects how much the business is funded through the two key common sources – owners’ capital invested initially and the money accumulated over time from profitable operations.
WHY SHOULD THE BALANCE SHEET BE IMPORTANT TO YOU?
As an investor, you need to ensure that the company you have invested in has good potential for future growth, and will yield good returns. The balance sheet helps you get answers to questions like:
- Will the firm meet its financial obligations?
- How much funds have already been invested in this company?
- Is the company overly indebted?
- What are the different assets that the company has purchased with its financing?
- Is the company using its funds efficiently?
These are just a few of the many relevant questions you can answer by studying the balance sheet. The balance sheet provides a diligent investor with many clues to a firm's future performance.
HOW DO I OBTAIN AN ANNUAL REPORT?
Annual reports are mailed automatically to all shareholders on record. If you wish to obtain the annual report about a company in which you do not own shares, you can call its public relations (or shareholder relations) department. You may also look at the company website, or search the internet; there are several sources on the internet providing such information on public companies.
All listed companies are required to submit the financial reports available in the public domain as per SEBI regulations. These may, hence, also be available with the two exchanges – Bombay Stock Exchange and National Stock Exchange.
HOW DO YOU USE EARNINGS INFORMATION TO MAKE AN INVESTMENT DECISION?
Your investment goals, determine how you use information about company earnings. If you are an income investor – one interested in earning immediate income from your investments – you probably want to invest in a company that is paying high dividends.
If you have a long-term investment strategy, dividends may not be as important to you. In this case, you may choose to compare company financial, which indicates whether a company is oriented for income, growth, or a bit of both. By comparing the financials for different companies in the same industry, you can find characteristics best suited to your investment goals.
A convenient way to compare companies is through Earnings per Share (EPS). It represents the net profit divided by the number of outstanding shares of stock.
When you compare the EPS of different companies, be sure to consider the following:
- Companies with higher earnings are financially stronger than companies with lower earnings.
- Companies that reinvest their earnings may pay low or no dividends, but may be poised for growth.
- Companies with lower earnings and higher research and development costs may be on the brink of either a breakthrough or a disaster, making them a risky proposition.
- Companies with higher earnings, lower costs and lower shareholder equity, might go in for a merger.
Now that you know how to read an annual report and analyze the financial health of a company, let’s take one step further and understand how to analyze various stocks in the market. Remember, there are different stock market strategies that use various methods of analysis. Click here to learn more.
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