Navigating the Annual Report Maze
Harry Potter may be big, but there is an even bigger series coming in 2003. There will be millions printed and, better yet, they’ll come to you for free. Oh, these books have been out for some time, but until last year, they didn’t really catch on. Now, however, more people than ever are paying attention when these books arrive in the mail.
While these books go by many names, they are generically known as “The Annual Report” and every stockholder of every public company gets one. They may be sent by snail mail or by email. Generally, they are about the length of a short novel, but don’t be fooled, this book is not a work of fiction…well, it’s not supposed to be. In essence, the corporate annual report is a report card on the company in which you have invested you money and, despite the bad publicity of the past year, the vast majority of annual reports really are fairly accurate.
The annual report should be an extremely important part of your financial year, especially if you have your retirement tied up in the market. Unfortunately, it’s sometimes hard to navigate through the verbiage most companies offer you. While we won’t be able to tell you everything to look for in this article, we can at least offer you roadmap with the major points of interest.
There is certain information you should expect to see in every report. This standard information is necessary so you will be able to compare your company with others in its industry. There is one small catch – management spends a lot of time deciding what to say and how to say it. A savvy investor will spend as much time considering what is not said as what is said. This isn’t said to criticize corporate executives. Management is required to tell the truth, and generally does, but everyone who writes business letters knows that it’s not so much what you say as how you say it.
So what should you expect? Let’s take a look.
The Chairman’s Letter is a letter to the stockholders from the Chairman of the company’s board of directors. It should be a discussion of the results of the company’s most recent year. A good letter will compare the current year’s results with what the company predicted. Look for a plausible explanation of why the company achieved the results it did. Look also for a rational description of what management plans for the company’s future.
Regardless of whether the news is good or bad, management can’t change history. A good management team will tell the truth about a company’s results of operations and its financial condition. The mark of good managers isn’t how they do when business is good. Anyone can make money in the good times. However, a good management team let’s you know when times are tough and tells you how the company will meet the challenges.
Beware of rosy assertions about the future in bad times, although in the current environment you probably won’t see too much rosy prophecy about the future from management.
The auditors’ are the folks who are supposed to be looking out for the stockholders. As recent history suggests, that’s not always true, but by and large, auditors’ try to get it right.
The auditors’ job is to test the transactions underlying the financial statements management publishes. If they are happy with the numbers, and everything else in the annual report, they will issue their opinion on the financial statements for inclusion in the annual report. It is important to know that even though the auditors really only issue the report on the financial statements, if the information in the annual report package is inconsistent with the financial statements, they must withhold their report from inclusion in the annual report package.
The kind of report is very important. Without discussing the differences in reports the auditor may issue, let’s just say that you want to see a clean report. This is one that has three paragraphs and says in the report that the financial statements are “fairly stated in all material respects” in accordance with the applicable accounting rules. Otherwise, a red flag should go up in your mind to read everything else more closely.
Management’s Discussion and Analysis
This is a much more detailed version of the Chairman’s Letter. Generally, you will read about the reasons for changes in the various categories of the income statements – sales, expenses, income taxes and net income. You should expect to see a comparison of current operating results with prior years and an analysis of the performance of various business units, current and anticipated market risks along with competition. If there were any acquisitions and divestitures during the period, expect a discussion of these as well as information on any reduction in value of assets beyond normal (impairment of assets).
This is also the area where you will find information on the company’s liquidity and ability to meet short-term and long-term obligations, if any.
In short, this is the “MD&A” is where management fleshes out the Chairman’s Letter and tells you why the company did good or bad in the past year, how it intends to employ capital in the future and, if needed, where it plans to get the capital from.
Comparison of Financial Results over Five or More Years
This section is included to help you understand the company’s trends over time. It’s basically intuitive. You want to see a positive trend in sales and earnings. You hope to see a change in expenses commensurate with or less than the increase in sales. If you see an increase in sales, along with a higher percentage increase in cost of sales, this could suggest the company is battling to keep its market share by charging less for the product. This translates into a rate of earnings increase at less than the related sales increases – generally not a good thing.
You will also be treated to a number of ratios such as return on assets and equity. Working capital ratios are key also. The higher, the better, because this indicates how well your company is positioned to meet its obligations as they come due. Too high of a ratio, however, may suggest management is holding onto cash to the detriment of the stockholder.
In contrast, ratios that suggest increasing debt load, as a percentage of equity or assets, is not good. Debt to equity and long-term debt to equity are typical ratios you might see. Keep a watch on these ratios if they increase. This may or may not be good, depending on other ratios and circumstances.
Income Statements or Profit and Loss Statements
This is the part of the report that tells you what makes up the earnings (hopefully) of your company. Positive trends in recurring income (sales, franchise fees, etc.) are good. If expenses increase in proportion to or less than sales, this is also generally good. However, don’t just look at the bottom line. If you see a huge bottom line, but most of it comes from one-time revenue sources, take a look at the source. Looking at the reason for the one-time revenue will give you clues to how well the company may do in the future.
Simply put, the balance sheets tell you the historical cost of assets, obligations to creditors and the value of assets left for the shareholders. In short, you would hope to see nothing less than an increase in the “shareholders equity” section of the balance sheet with most of that coming from earnings. If equity increases mainly due to earnings, this suggests the company is able to generate sufficient capital to meet current and, perhaps, future capital needs without obtaining outside capital. Increases in equity because of sales of additional stock may or may not be good depending on the reasoning behind the issuance of additional stock.
Likewise, increases or decreases in assets and liabilities could have positive or negative connotations, depending on the reasons for the changes. The devil, as they say, is in the details, or other parts of the annual report. This is why it is so important to look at everything in the annual report and not just the financial statements.
Cash Flow Statements
Many people believe the statements of cash flows are the most important statements to look at. “Cash provided by operating activities” is the measure of how much cash the company’s business generated. Hopefully, this will be a positive number. Unfortunately, when a company is in a high growth mode, it may take cash to fund operations. In this case, take a look at changes in cash as a result of “financing activities.”
“Financing activities” include the issuance of stock and debt securities and the payment of debt, dividends or repurchase of stock. If the company didn’t have sufficient cash reserves at the beginning of the year, you might see an overall increase in cash from financing activities, especially if the cash from operations was a negative amount. Another reason for an increase in cash provided by “financing activities” is a large use of cash for “investing activities.”
“Investing activities” include investing in fixed assets and debt or equity assets of another company. The type of investments you should expect to see will depend on your company’s operational methods. However, you should never make the mistake of thinking it is desirable for investing activities to always provide cash flow. After all, a company that isn’t growing and adding to its investments is generally living on assets that are continually reducing. At some point, if not replaced, investments will disappear and so will the company’s ability to generate a return to its shareholders.
Notes to Financial Statements
Every set of financial statements requires numerous disclosures to tell you what ‘s in the numbers you’re looking at. The information here is enough to drive us CPAs crazy, so we know it will drive you crazy. However, this is an area of the financial statements you cannot ignore. The notes may well include information that will change your mind on how the company did and what kind of financial shape it’s in. The form and content of the Enron Notes to Financial Statements should have been a tip that something wasn’t quite right. While the notes are sometimes long, undue length and complexity should be a tip that more investigation is necessary.
We try to keep these articles to approximately 700-800 words. This article is roughly double that target and we’ve just scratched a little part of the surface. This, in itself, should tell you that there is more to tracking and understanding your investments than looking at your statement once a year. When you get annual reports this year, do us a favor and let us know if you have questions. Looking at the annual report with seasoned professionals may be one way of minimizing your fears in this roller coaster market.
By the way, did we mention that this type information is equally important when it is your closely-held business. Perhaps it’s even more important. Don’t let warning signs pass you by. Give us a call if you need answers.
Have a great March!