Chapter 7.17: Company Annual Reports

• Company annual reports: What to read

  
  

  Annual reports are big documents. They generally run into over a hundred pages. Not all the information they contain is relevant to equity investors. Some of the relevant information is rather technical and can only be broken down by seasoned market players. Here, we have mentioned some of its sections that are of direct interest to you. They are mentioned in the same order as the one you would find them in in an annual report.
  
  

• Company information: This is normally the first significant section of the annual report. It gives all the vital information about a company, such as its – objectives, strategic intent, products, market position, management etc. This section should be read with care because it helps us understand what the company has set out to achieve and whether it has the right people and resources to achieve these objectives. It also helps us understand the image a company is trying to create for itself in the market and the kind of customers it wants to cater to. All this is critical for you to ascertain the external factors that could affect a company’s business in the future and develop future expectations based on them. You may also evaluate future activities of the company on the basis of whether or not they are in line with these broad objectives.
• Director’s report: The board of directors (BOD) watches over the activities of a company on an ongoing basis on behalf of its shareholders. Director’s report is a summary of what went on in the company throughout the year, how the company faired in the opinion of the directors and what significant activities investors should lookout for in the future. It starts with a summary of the company’s financial performance during the year and explains why figures look the way they do. It also discusses the major corporate developments that took place during the year and their impact on current and future earnings. Lastly, it gives a peep into the future by giving an account of the management’s plans and how they might auger for the company. A similar assessment is presented in the ‘management discussion and analysis (MD&A)’ section of the annual report; however, it is authored by the Managing Director. Since the board is supposed to be closer to the shareholders and fairly detached from the management, shareholders have more faith in the director’s report.
• Corporate governance report: This section talks about the internal governance mechanism of the company. Since the board is the principal source of internal governance, most of the information about the board and its members can be found here. In most annual reports, a list of the board members is given right at the outset. This must be used to verify their independence. Board members must not be related to the management in any way – members, close relatives, friends, suppliers, close customers etc. The board will naturally include the representatives of the largest shareholders, promoters and some members of the management. However, their percentage must be very small. Other things that you must ascertain about the board members is their qualification, experience, compensation, stake in the company, membership of boards of other companies and commitment to the company, as evidenced by their presence in board meetings. All this can be found in the corporate governance section of the annual report. In general, board members who have a stake in the company and are members of only a couple of other boards at best, will be able to devote themselves more to the company’s shareholders. The corporate governance section also gives an account of the activities of the board during the year. The board sets up a number of committees, such as the compensation, audit and finance committees. The corporate governance report contains information about the structure, membership and accomplishments of these committees. From this, one can evaluate the efficiency and transparency of the board.
• Auditor’s report:To ensure that all financial statements and notes to them are reported accurately and honestly in the annual report, security market regulators require them to be reviewed by a qualified external auditor. The report of the audit has to be presented before the financial statements in the annual report. It contains a brief note on the scope of the audit, the auditor’s views on the reported financial figures and his major points of concern, if any. Companies are also required to have in place a mechanism of internal control and audit to ensure the adoption of ethical business practices and honest financial reporting. External auditors assume that these mechanisms are working efficiently, without necessarily scrutinize them. Investors should go through the auditor’s report to ensure that everything mentioned in the financial statements is accurate and reliable, to the best knowledge of the company. They must ensure that the auditors are independent, i.e. not partial to the management in any way. Auditor impartiality can be questioned if the audit firm is in anyway related to the management—friends and family, customers, business partners etc. over the years there have been many instances of companies going bust subsequent to auditors not being able to present an entirely satisfactory view of their financials. It must be noted though, that auditors can only do their job based on the information provided to them by the management.
• Financial statements and notes: The three principal financial statements—the income statement, balance sheet and cash flow statement are presented in the annual report. They are presented on standalone and consolidated basis, i.e. exclusively for the company and for the company, including its subsidiaries. We have discussed financial statement analysis at length in previous sections. Notes to accounts are presented after the financial statements to elaborate on their contents. Changes in the company’s accounting practices, such as the method for calculating depreciation and inventory, too are mentioned in the notes. A figure that appears very impressive on a financial statement may completely lose its charm upon looking at the notes to accounts. For example, a company may have reported very high sales on the income statement. However, upon looking at the notes, it may be discovered that most of these are credit sales. This is an unhealthy proposition. This is why it is important to go through the notes.
• Shareholding pattern: The shareholding pattern is mentioned as a note to the equity section of the balance sheet. It contains a list of all shareholders who hold more than 5% stake in the company, along with their exact percentage holding. It is important for investors to know this because larger shareholders have a greater ability to influence the company’s important decisions. They can also put their own representatives on the board and influence its working. This can be injurious to smaller shareholders, particularly if the promoters’ stake is also relatively small. A company comes into existence because of the promoters’ vision. It is therefore ideal for them to continue steering it forward. Their holding must always be the highest. A smaller share will strip them off their freedom. Another category of investors that can be menacing is institutional investors. Corporate strategies are formed with long term objectives in mind. Financial institutions have a shorter term perspective. They want to make money fairly quickly and exit. Consequently, they may block decisions that could prove beneficial in the long run if they affect short term profitability. Also, if they exit abruptly, the market price of the company’s stock can take a beating.
• Historical comparison: Annual reports contain a summary of the company’s performance over the past five to ten years. This may be found at the beginning or at the end of the report. It is important to examine it because it tells us about the progress of the company over the concerned period. You may compare trends of sales and profits, fixed asset growth, major sources of income and expenses, cash position etc. over the period and spot areas of improvement and deterioration. Sometimes past trends also indicate a shift in the company’s strategy. These must be identified.

• What is management discussion and analysis

  
  

  Finally, we will look at the management discussion and analysis or MD&A section of the annual report. This section, along with financial statements, is considered by some to be the most important section of the annual report. It is written by the chairman and managing directors of the company and talks about the company’s performance during the period and guidance for the future. It generally consists of the following sections:
  

Components of the Management Discussion & Analysis section

• Review of the previous year: The MD&A section begins with a brief description of the company’s performance during the year. It predominantly talks about financial highlights, such as the sales revenue for the year, EBITDA and net profit margins, new customers acquired etc. In case the company has many verticals or subsidiaries, the performance of each of them is also discussed. The performance is compared with the previous year and key reasons for the change are highlighted.
• Business environment: The discussion then moves to the environmental factors that dictated the company’s performance during the period. It starts with the state of the overall economy in which the company operates. This includes the inflation rate, demand patterns, input costs, exchange rates, economic growth rate etc. It then gives an account of the changes in government policy, geo-political factors and industry-specific factors that influenced the company’s working.
• Keys to success:In this segment, the management talks about the pillars that led to the company’s success, given the state of its environment. These may include strategic changes made by the company, new control mechanisms introduced, diversification in products, acquisition of new categories of customers, moving into new geographies and operational changes adopted.
• New initiatives: A company may have taken new initiatives, such as starting a new product line, forming key alliances, investing in new assets, forming new collaborations etc. These are discussed in this section. It states when these initiatives are expected to be completed, how they impacted the current year’s performance (if complete); and how they may impact future performance (if not yet complete).
• Future plans, challenges and opportunities: In this section, the management discusses what the future holds for the company. It discusses the new strategy the company is going to adopt, the new assets it’s going to invest in, new markets and verticals it may enter, strategies to cut costs, new hiring plans, new capability development etc. The section also contains information on the future challenges and opportunities that the management is able to see and how it intends to deal with them. All this is critical because it directly affects future earnings and consequently the stock price.