How to Read an Annual Report?

Fundamentals · Oct 2, 2019

Most of the people can read nowadays (the literacy level is close to 99%), yet reading an annual report of a company is a different story. It can be very confusing for an investor to figure out what are the key things to look after and what information is worth reading. It’s not enough to be able to read, a good investor should also have a special kind of literacy: financial literacy.

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In this article, we’ll explain how to read annual reports efficiently in order to extract the most valuable data from it. We’ll also share our opinion on what information in these huge 200-300 page documents can be ignored to save your time. Financial reports are being produced not only by the big corporations but also by non-profit organizations and even government entities. In this article, we’ll only cover financial reports of public for-profit corporations.

Table of Contents

What is an Annual Report?

An annual report is an official and legitimate document that a company publishes every year. Usually, it can be found on a company’s official website, on a special page named like “Investor Relations”, which is usually located in an “About Us” section.

The annual report contains a lot of important financial data such as income, expenses, debt, assets, liabilities, etc. The purpose of the report is to present the key financial information to the public and the shareholders, as well as to mention the most important problems and expand on what a company is planning to do to solve those issues.

Different Types of Reports

There are two main types of financial reports based on certain accounting standards:

  • Generally accepted accounting principles (GAAP)
  • International financial reporting standards (IFRS)

Generally accepted accounting principles depend on the country in question, those principles are unique to each country such as the U.S. (U.S. GAAP), Canada, France, Germany, Russia, China, Switzerland, United Kingdom, India, etc. Those standards can vary quite a lot.

International financial reporting standards are the same for all of those companies if they use them. Usually, if it’s a large international corporation that operates in many different countries, it would issue IFRS-compliant reports. Sometimes, those multinational corporations publish many different reports for every country they work in, complying with the accounting standards of each and every country they operate in.

Some countries, like Canada in 2015, accepted the international financial reporting standards as the main practice for all publicly accountable enterprises, but, so far, the majority of big countries, including the U.S., keep using their own accounting standards.

Large firms in America have to also file standardized “Form 10-K” reports in addition to the annual reports to their shareholders.

Why do Companies Publish Those Reports?

First of all, they are required to do so by law. Usually, the law states that a public company with publicly traded shares has to publish some form of a regular report so all its investors would know what is going on with their business.

Secondly, these annual financial reports are some form of self-advertising and PR strategy for a company, it’s a good place to present data-backed arguments. A big advantage of a privately-owned firm is that it’s not obligated to publish anything like that and disclose its financial data.

The Content of the Report

A financial report often would contain the following components:

  • General information and a description of the business
  • Current state of the business, summary, overview and key numbers
  • Risk factors
  • Legal proceedings and due diligence
  • Selected financial data
  • Consolidated financial statements
  • Additional selected financial information

Each of these chapters may include several subchapters as well.

What Should You Look For in a Financial Report?

The main thing to understand about the financial reports is that a big part of them is subjective and selective, and a small part, which is the most important and interesting one, is mostly objective and helpful.

The most important one is the one with consolidated financial statements, which includes:

You can read everything in the report if you have time and almost no company would openly lie about their results, like Enron did. However, they would pick the most favorable numbers to present and the overall picture, based on those selected figures, would usually look bright.

A company would try to present itself as a very good one by mentioning things like environment (and what a company does about it), charity, community support and those important things that the company cares about. It’s great (or not, according to some economists) that many modern corporations are not all about money and profits (at least many of them say so), but for a neutral and profit-focused investor this information is not that crucial.

In the balance sheet, income statement and the cash flow statement you would find raw numbers and they would be presented in a clear manner, without any distractions.

Sometimes, a company can modify its financial data a bit. For instance, some would show COGS (cost of goods sold) and some wouldn’t, but, typically, most of the big corporations follow the GAP or the IFRS accounting standards and their reporting practices tend to be similar.

Why Financial Reports are Hard to Read?

Financial reports are part of accounting practice which is a rather compilated field of study with its own terms, slang, and jargon. Economics, accounting, and finance are often considered to be sciences. Therefore, for someone who is not a specialist in any particular field, this information may be hard to read, the same way books about math or physics are hard to understand for a person without some basic knowledge.

If certain data is not favorable for a company brand and reputation, but it still has to be published, some specialists, who are responsible for creating financial reports, would occasionally overcomplicate things.

They may use a more vague term or skip something to make the overall picture look better.

There is a common phrase by Benjamin Disraeli, which Mark Twain and others popularized, that describes this phenomena:

“There are three kinds of lies: lies, damned lies, and statistics.”

Although it wouldn’t be fair to say that everything in all reports is false or misleading.

Financial reporting is an old practice that, throughout the years, has become a form of art in some sense. Companies try to tell a story and pretend to be objective and investors try to separate real data from fake narratives. That’s the essence of this game.

What Exactly Should I Look at in a Report?

Here are some of the numbers you should look for in an income statement:

  • Net operating revenues from sales
  • Cost of goods sold will reveal a profit margin and a gross profit
  • Selling, general and administrative expenses
  • Interest expenses and their growth. Big interest expenses would mean a bad and expensive debt
  • Income taxes paid
  • Net Profit and its history. This is the most important number

Here is what you can check in the company’s balance sheet:

  • Assets and their structure (cash, investments, inventories, property, etc.)
  • Liabilities and their structure (accounts payable, loans, long-term debt, etc.)
  • Total equity

A corporation usually publishes detailed information and many interesting numbers in their reports, yet it’s always hard to figure out what is valuable for your particular analysis, and what information you can currently skip. It’s recommended to explore the section of the report that you have the most concerns about. For example, if you are worried about company’s debt, look at its structure, its changes over time, etc. It’s a very troubling sign if a particular section of the report is suspiciously shorter than it used to be in the previous years.

How to Use the Data From the Financial Report? Example

The total equity (assets = equity + liabilities) shows a surplus of company’s real worth, which might be very different from its current market capitalization. For example in 2018 Coca-Cola’s equity was 19 billion according to its 10-k report, but the market cap of this company in 2018 was around 190 billions. This is not to say that this company is overrated by the market, it just shows how the real world, which is reflected in the annual reports and fundamental analysis, can be different from the technical analysis and the current market situation.

Researches, who can analyze companies based on their fundamentals, have a big advantage: they can compare the real financial data to the market reflection of it at a particular moment.

Why would the market value a company to be 10X of what it actually has in terms of the equity?

There are many reasons for that, one of which is that traders and investors know that Coca-Cola is a very reputable and stable American corporation that eventually, from their point of view, will worth 10X or more of its current equity.

In other cases, however, a big gap between the real financial data and the market value can reveal an issue and give you a warning that, perhaps, a certain company worth more or less than the market currently offers.

This was just one and tiny example of how the fundamental analysis can benefit an investor and there are many others.

For example, a professional financial analyst could notice something in a report that will give him a major hint, like the fact that a company somehow managed to restructure its long-term debt at a higher interest. The long-term debt stayed the same, but the interest payments became higher, such small detail is not always easy to notice. The major financial media might never report about that, no one, except the management of the company, knows that, but an accurate analysis might find such information and use it for his advantage.

Another example of how such a comprehensive analysis can help would be if a huge corporation increased its activity in one market, say, China, and decreased it in Germany. The net profit stays roughly the same, so it’s hard to notice without digging, but the structure of this net profit changed and later it might lead to something or it might reveal that the company changed its policy without an announcement.

Such findings might not matter much for day traders and in a short-term scale, but, in a long-term perspective, they’re quite valuable.

Is There Another Way to Get Valuable Information From Annual Reports?

Interestingly enough, lazy investors already found a way to extract the most important fundamental information from those reports without reading them. They did that by inventing various indicators such as the quick ratio, the current ratio, return on assets, EBITDA and many others. With these metrics, you can easily check how a company is doing in terms of its fundamental values and use these indicators in investing or trading.

There are some indicators that combine two worlds of the fundamental and technical analysis in one number. One of them is the P/E ratio that shows the correlation between the current market price of a company and it’s actual earnings per share. Those indicators can be particularly helpful for those investors who take into account not only technical and current metrics but also some important fundamental data from the financial reports of various companies.

accounting   analytics   business   finance   indicators   investing   microeconomics   management   fundamental analysis

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