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.)

How to read the Cash Flow Statement – Part 1

Have you heard the statement: Cash is king? A business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive. Seems logical that investors would first look at the Cash Flow Statement in an Annual Report – right?

Unfortunately, most investors in the stock market – even those who have been investing for many years - do not understand or know how to interpret the Cash Flow Statement. Just looking at the Balance Sheet, Profit and Loss statement and the Management Discussion and Analysis is not enough. The real state of a company’s finances is hidden in the Cash Flow Statement and the Notes on Accounts.

With another accounting year coming to a close on Mar 31, 2011, this is as good a time as any to learn the basics of the Cash Flow Statement:-

The Cash Flow Statement allows you to check the different sources of cash inflows into a company during a particular year vis-a-vis the prior year, how much cash was spent, and what it was spent on. Cash inflows are positive, cash outflows are (negative). The three parts of a Cash Flow Statement enable you to understand what a company’s management is doing with the cash at its disposal, by comparing the figures with those appearing in the Balance Sheet and Profit and Loss statement.

Part 1: Cash Flow from Operating Activities

The Net Profit before tax and exceptional items from the Profit and Loss statement is adjusted with depreciation, interest, provisions, profit/loss on investments, debtors, inventories, creditors to arrive at the cash generated from operations. Tax and exceptional items are then adjusted to arrive at the Net Cash from Operating Activities.

Though it may seem counter-intuitive to non-accountants (like me), depreciation is considered an inflow (it is an expenditure in the Profit and Loss statement, but the cash is not paid to any one and remains within the company); creditors/accounts payable is an inflow (because they haven’t been paid yet); debtors/accounts receivable is an outflow (because a ‘sale’ has been accounted in the Profit and Loss statement but the money hasn’t been received yet).

Net Cash Flow from Operating Activities should preferably be positive, and greater than the previous year’s if the net profit has gone up. Newly set-up companies, particularly those in high growth fields like Information Technology or Bio-technology, often have negative cash flows from operations in their initial years. They need to ramp up operations quickly to meet demand but may not be able to negotiate good payment terms from their clients.

Negative cash flows from operations of established companies, if over prolonged periods, indicate that there is something amiss with the business model, or the management has questionable integrity and is diverting cash to unlisted subsidiaries or to related parties.

Investors need to be particularly wary of companies that show good top-line and bottom-line growth year after year, and pay taxes and dividends but show negative cash flows from operations. Where is the cash to pay the taxes and dividends? It comes from regular borrowings and share issues. If such a situation continues for a few years, the debt burden will eventually sink the company. Many realty and high-flying infrastructure companies, and investor favourites like Bartronics, Cranes Software fall within this category.

(Note: The next two parts of the Cash Flow Statement will be covered in Thursday’s post – so please stay tuned.)

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