Guide in reading annual reports

SURPRISINGLY, reading an annual report is not often done by most retail investors.

An annual report is usually the only published document that provides investors a yearly picture of a company.

It is like reading your medical exam results. It has its own jargon and tells you about the condition you are in.

In reading the annual report your goal should be to be able to understand a few things about a company. This includes the products a company sells or the services it offers, its business model, and how it makes its money. And of course, how profitable or unprofitable it is.

It should take you less than an hour to finish and find most of the things you need to decide whether the business is worth investing in.

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When you read the business overview and development section, you will learn things about the company and its business model. If the business does not interest you or if you couldn’t understand it you can always move on to the next company. This practice should save you time and effort in finding your next bagger.

Browsing through the chairman and CEO (chief executive officer) messages should give you a summary of how the business did and their future expectations. You should also read the management discussions and analysis. It will tell you a summary of any major changes in the financials and explain the reasons.

An independent auditor’s role is to increase reliability of the financial statements. For the financial statements, look if the independent auditors gave an unqualified opinion or a generally clean bill of health.

Check if the following is rising or falling: sales, gross margins, net profits, operating cash flow, debt and dividends as a share of profits.

Don’t forget to read the notes to financial statements to get more insights into the business.

For any areas which indicate worse than expected results, look at the explanations and discussions given by management.

There are three important statements to look at the financials: the balance sheet, the income statement and the cash flow statement.

The balance sheet tells you about the financial position of the company at a point in time. You will see the assets, liabilities and shareholders’ equity here. A company with too much cash might not have been using it efficiently. One with too much debt might have liquidity problems in the future. A large amount of physical depreciating assets such as machineries could indicate future large cash expenditures to replace those assets. A larger percentage increase in receivables versus sales could mean more sales are being made on credit.

An income statement tells us how much the company made during a period. An annual report covers a year. Increasing sales coupled with decreasing margins might mean that the company is selling more by reducing prices or not passing on additional costs.

The cash flow statement shows how healthy cash inflows and outflows are and where cash goes. Focus on the three sections: cash flow from operating, investing and financing. Operating cash flow is usually preferred to be positive; the investing section shows whether you are investing or divesting, while the financing section shows whether you are borrowing or paying your liabilities or paying out dividends.

To better analyze the financial statements, you may use the items in one statement and relate it to another. An example is the Return on Assets (ROA). Net income, an income statement item, is divided by assets from the balance sheet. The ROA describes how well the company used its assets to produce its earnings. A higher number compared to the previous years or competitors means better.

Financial statements are made by following generally accepted accounting principles (GAAP). These reporting rules, however, do not always reflect the true economic value of a business. Thus, adjustments are needed sometimes.

The P/E is a quick way to compare a company’s selling price with its net income it reported in the recent period. P refers to price while E refers to earnings.

P/BV compares the selling price versus the book value or net worth of the company. A ratio of less than one means the company is selling for less than the recorded value.

Reading a series of annual reports will tell us much about what the management did before including any changes to their core mission and any ups and downs they handled over the years.

Take note that an annual report tells more about the past. But you can use that information to forecast the future.

There will be many things you will learn about companies, industries and the economy as you read more annual reports.

Expect that reading annual reports could be a struggle at first. But you should get better at it over time.

Josefino R. Gomez is a registered financial planner of RFP Philippines. To learn more about personal financial planning, attend the 96th RFP program in July 2022. For inquiries, email [email protected] or text at 09176248110.