As you start analyzing annual reports, you’re likely to notice that each company has its own style and approach. Additionally, writing the annual report is often an ongoing company project and not something that happens just at the end of the fiscal year. As you read the annual report, you may notice that some sections are clear and straightforward, while other sections may be almost indecipherable and require your close attention. Several sections may be lengthy, and others provide just a brief overview. These inconsistencies are normal because different company departments and individuals write different sections of the annual report.
The following guidelines can help you find your way through the various sections in an annual report:
- Reading the letter to the shareholders: Although you usually find the letter to the shareholders within the first couple of pages of the annual report, save reading this letter for last and then compare it to the facts you uncover about the company. Is the CEO being truthful with the shareholders? What is the CEO’s view of the company’s operations? What does this letter tell you about the character of the CEO?
- Viewing the company overview: After the letter to the shareholders, the annual report usually presents an overview of the company, which includes a description of the company’s products and its channels of distribution.
- Figuring out the ten-year summary of financial figures: Companies often provide selected financial data. The ten-year summary of financial figures should indicate the steady growth of the company, if there was steady growth.
- Analyzing the management discussion and analysis of operations: The management discussion, which is one of the more significant sections of the annual report, usually focuses on corporate operations. This section addresses such issues as how technology has impacted the company, how the company copes with competition, and what management expects to accomplish in the next year.
- Scrutinizing the independent auditor’s report: Toward the back of the annual report, you generally find an opinion letter with a title like Report of Independent Auditor or The CPA Opinion Letter. Keep in mind that the company pays the auditor — a fact that may sometimes lead to a biased annual report. (During the savings-and-loan crisis, for example, the annual reports of many thrifts didn’t reveal their shaky financial situations.) The first part of the auditor’s opinion is standard. The key words to look for are “In our opinion, the financial position stated in the annual report has been fairly stated in all material aspects and in conformity with generally accepted accounting principles,” or something to this effect. If this statement isn’t used, a problem may exist.
- Examining financial statements: Many companies belong to conglomerates that operate in numerous industries and countries. In such cases, it isn’t possible to compare company performance to any industry average. The only way you can judge whether the company’s performance is improving or declining is by comparing current financial ratios to the firm’s previous ratios.
Often, the notes to the financial statements are the most revealing part of a financial statement. Notes define accounting policies and disclose any pending litigation and environmental issues.
- Finding out about subsidiaries, brands, and addresses: Knowing what the company owns and where the company operates is important. This knowledge can help investors evaluate the political risk of their investments. For example, during the time of South Africa’s apartheid, many individuals boycotted Eastman-Kodak. They protested how Kodak products were used in South Africa. In this age of social conscience investing, you might not want to own stock in a company that supports initiatives and products that you disagree with or believe are unsuitable.
- Perusing the list of directors and officers: The board of directors listing usually appears on the last page of the annual report. Few reports provide details about the experience and professional backgrounds of these individuals. (Director biographies are usually included on the company’s proxies to assist you in voting for new or incumbent candidates for the board of directors.) If you feel that this information is intentionally deleted, you can call the company’s investor relations department and ask for a background biography of each director.
- Investigating the stock price history: Evaluating the company’s stock price history may provide you with some useful insights. For example, is the current stock price the highest in the history of the company?
When analyzing the financial statements and developing ratios, you should note the following information:
- Growth in sales: Are sales increasing or decreasing?
- Growth in profits: Are profits growing as fast as sales? Are high interest payments eating away at profits?
- Profits: Have earnings per share increased every year? (If not, why not? There may be a logical answer. For example, an aluminum company’s profits may not rise every year because the commodity price of aluminum fluctuates.)
- Research and development spending: Does the company spend the same amount on research and development as similar firms?
- Inventory: Is a change in accounting procedures causing inventories to go up or down?
- Debt: Are debts increasing?
- Assets: Are most of the company’s assets leased?
- Litigations: Are there any pending litigations (lawsuits)?
- Pension plan: Is the pension plan in bad shape?
- Changes in procedures: Is the company using accounting changes that may inflate earnings?