How to read an Annual Report

It is that time of the year when Annual Reports start hitting the mailboxes of investors. There are three things you can do with the Annual Reports you receive:

1. Toss it into the recycling pile with the old newspapers and beer bottles without even opening the envelope

2. Check the Profit & Loss statement and the dividend amount before tossing it into the recycling pile

3. Actually take the trouble of going through the Annual Report in detail to find out whether the company whose stocks you are holding is growing, stagnating or flying kites.

In the wild west days in the USA, there used to be a saying: The only good Indian is a dead Indian. Of course they didn’t mean people from India (though Columbus thought he had reached the East Indies – the islands of South East Asia - when he landed up on the shores of the Bahamas).

If you believe that the only good Annual Report is the one lying ‘dead’ in the recycling pile, then this post isn’t for you. If you think otherwise, please read on.

First, go to the Cash Flow Statement to find out if the company is generating enough cash from its business to finance part or most of its expenditure for growth. If you don’t know how to read a Cash Flow Statement, please read my posts of  Mar 22 2011, Mar 24 2011, Mar 29 2011 and Apr 5 2011.

Next, check out the Profit & Loss statement and the Balance Sheet. Of particular interest should be inventory and accounts receivable (if percentage increases are more than the sales percentage increase, they are warning signs); increase in equity capital and loans (not a good sign if these increase frequently); cash in hand/banks should tally with the figure in the Cash Flow Statement (so that a Satyam-like situation doesn’t recur).

Next comes the Directors’ Report and Management Discussion and Analysis. Read through these even though there will be hardly any negative feedback in them. They will give an idea about the industry and the company’s growth plans and (rosy) prospects.

Last, but not the least, are the Notes on Accounts. However boring these notes may seem – particularly to non-accountants like me – they contain a wealth of information that usually have adverse implications on profits. If a company suddenly announces a surprising turnaround or spectacular recovery in results, chance are that they have ‘cooked their books’ (a Punj Lloyd speciality). Look for changes in depreciation calculation and inventory valuation, which can significantly alter profits without an actual improvement in performance.

Also look at the court cases – usually with various tax authorities regarding disputed demands. Prudent managements will make at least part provisions against likely future liabilities. For companies that provide stock options to their employees, use the diluted EPS to calculate P/E ratios. For companies that have several subsidiaries – listed or otherwise – use the consolidated results for analysis.

There are many other things to look for in an Annual Report – but these are the broad areas for a first-cut analysis to ensure that business and growth are on track.

(Note: Thanks to reader Jalal for suggesting this topic.)

Why technical and fundamental analysis are the two feet of a stock portfolio

Have you tried to stand on one foot for any length of time? Unless you are an expert in hathayoga, you won’t be able to do it for more than a few minutes. Even if you are able to balance yourself for 10 minutes on one foot, what purpose will be served? You won’t get anywhere! Like you, your stock portfolio needs to use two feet – technical analysis and fundamental analysis – to achieve success.

Being an engineer by training, technical analysis always appealed to me more when I started investing in the stock market. Semi-logarithmic charts, trend lines, symmetrical and right-angled triangles, rectangles, parallelograms, Fibonacci retracement levels were familiar terminology. I took to them like a duck to water.

Well, not quite. After losing a ton of money, I came to the fairly simple conclusion that familiarity with the terminology was not the same as knowledge of the subject matter. Understanding different chart patterns is not of any use unless you know which stock charts to study. But the alternative wasn’t intellectually stimulating enough.

Fundamental analysis meant dissecting the contents of Annual Reports. No exponentials or double integrals to apply one’s math skills. Just a bunch of numbers that needed to be added and subtracted and divided to unravel the secrets of well-disguised financial performances. Low-level clerical stuff – or so I thought.

Finally, a broker friend opened my eyes. He only had a B. Com degree but was rolling in cash and driving around in new cars. So I asked him what the secret was. His answer shook me up. Just plain grunt work, he said. Wading through annual reports to find financially strong companies that generate cash and don’t require too much capital to function.

How do you decide when to buy or sell?, was my next question. This is where a bit of knowledge of technical analysis can help, he responded. You have to first determine the trend – whether up, down or sideways. Moving average crossovers and support-resistance levels can then be used to determine entry and exit points.

That is all there is to it. No rocket science. Just school-level arithmetic, including familiarity with graphs and the discipline to go through annual reports in detail. Don’t have time and energy for all this hard work? Avoid individual stocks; buy mutual funds.

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