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Annual Reports-How To Decipher Them From Stock Market Angle-VRK100-12092006
Annual Reports-How To Decipher Them From Stock Market Angle-VRK100-12092006
Annual Reports-How To Decipher Them From Stock Market Angle-VRK100-12092006
in
MUMBAI
September 12th, 2006
www.scribd.com/vrk100
OR
http://groups.google.co.in/group/random-thoughts-on-investments/files?hl=en&&sort=date
HOW AND WHAT TO READ FROM COMPANIES’ ANNUAL REPORTS
Annual reports often conceal more than they reveal. Yet they are perhaps the
best way to tell if the companies you are invested in are up to any good. Annual reports
are designed to satisfy the needs of existing shareholders, potential shareholders,
creditors, economists, financial analysts, suppliers and customers. Financial statements
are the heart of an annual report. Financial statements include a Balance Sheet, Profit
and Loss account, Cash Flow statement, schedules forming part of the balance sheet
and accompanying notes. Other important sections in an Annual Report include
Management Discussion and Analysis, Chairman’s speech, Directors’ report, Auditors’
report, Corporate Social Responsibility statement and Report on Corporate Governance
and other shareholder information.
When we receive these reports, we are tempted to put them aside or pass them
straight on to a garbage can. Many investors do not care to leaf through them. If one
goes through the reports, one can have a fair idea about the company’s strengths,
weakness, opportunities and threats, which will enable investors to take informed
decisions about a company’s future performance.
Let us now try to find some key takeaways from the annual reports:
It is a very important document in an annual report. And it certainly has the most
immediate impact on a stock price. The profit and loss account gives vital information on
the operations, profitability and growth of the company. It summarizes the financial
year’s operations of a business in the bottom line, which after accounting for every
expense could be either a profit or a loss. The important components are given below.
Total Income: The first item in a P&L account is sales revenue. It indicates whether or
not the company is growing. If revenues are growing rapidly, it is a clear signal that the
company is doing well. However, this has to be seen in the light of profitability and
efficiency of operations also.
Other income: It is so called because it does not arise out of the main business of the
company; it includes profit on sale of asset, insurance claims, dividends received from
subsidiaries, and income that cannot be included in sales revenue.
Expenses: Cost of production and other expenses are detailed here.
BALANCE SHEET
A Balance Sheet is a statement of the financial position of a company as on a
specific date. Usually, a Balance Sheet provides information as at the beginning of a
financial year and as at the end of the financial year, so that readers can analyse the
changes that have occurred during the financial year. A balance sheet is divided into two
halves, Asset and Liabilities. In the standard accounting model, the total of assets is
equal to liabilities. As such, both halves are in balance. They are in balance, because,
from an economic point of view, each rupee of assets must be funded by a rupee of
liabilities. Every time the stock market booms investors flock to it, thinking they can make
quick and easy profits out of the stock market. They just look at the net profit figure and
Current Liabilities: Current liabilities are short-term funds that cater to the working
capital needs of a company. These funds are in the form of credit purchases and short-
term loans, which are extended by the suppliers.
Current assets: Working capital or current assets fund the day-to-day operations of a
company. A company cannot wait for the payment expected in lieu of the goods
previously manufactured and sold. It has to maintain a stock of raw materials and
finished goods to ensure that the production cycle is running continuously. Similarly,
credit sales have to be provided for. Additionally, some cash is required for day-to-day
expenses. Current assets, unlike fixed assets, get converted into cash at periodic
intervals in a financial year.
Fixed Assets: Fixed assets are plant, machinery and building. By their very nature these
are immovable assets with a long life span. Importantly, they are the revenue-generating
assets of a company. They process the raw material and produce the finished products,
which the company sells and earns a profit from.
Investments: Many companies invest their surplus funds till they find a suitable use for
them. They could then be invested in either creating more fixed assets or augmenting
the working capital. Sometimes, they go for acquiring other firms within the country or
abroad. Recently, a lot of companies have acquired foreign companies; for example,
Tata Tea, Dr.Reddy’s Labs, Ranbaxy Labs, etc. These assets do earn a return for the
company. These investments could either be in the form of short-term funds (for
example, liquid mutual funds or short-term fixed deposits) or kept in medium term
instruments. But if investments are maintained at a high level and form a major chunk of
the total funds, it is a cause for worry. The point is that if the core business is not in need
of funds and the same condition is expected to prevail in future, this money can be given
back to the shareholders. It should also be kept in mind what rate of return these
investments are contributing to the balance sheet. Market value of investments of
investments held by such companies as ICICI Bank, IDBI, IFCI, Tata Investment
Corporation and a number of companies and a number of non-banking finance
companies is vital in putting value to their stocks. This information is available only once
a year, making the investment decision a bit tricky. Exide industries had acquired ING
Vysya Life Insurance for Rs 257 crores (at cost) as per 2005-06 balance sheet. Bajaj
Auto has an investment of Rs 496 (at cost) crore in ICICI Bank and Rs 193 crore in its
two insurance companies as at the end of March 2006. Its total investment book stands
at Rs 5,857 crore as at the end of March 2006.
Human capital: Another item that finds a place nowadays in an annual report is human
capital. Here, human capital is not merely one component of capital; it is the critical
component that forms the basis for other forms of capital: People with their expertise are
the sole creators of value to the customer and people through their effort are the key to
the optimization of its process efficiency. Human Capital is defined as the set of skills
which an employee acquires on the job, through training and experience, and which
increases that employee's value in the marketplace. Human resources valuation has
remained an academic exercise and largely ignored even in industries where the
expertise of employees is the key differentiating factor.
Companies need to deal with various entities during the course of their business,
which may result in financial transactions. But, to do so, the company needs cash.
Hence, it is essential for companies to improve their respective cash generating abilities.
Better management of these cash inflows and outflows and its respective short and long-
term obligations translate into an impressive cash flow statement.
What is a cash flow statement? It generally reflects how a company has generated
cash during a given period, in most cases 12 months, and how it has been deployed for
its core operations, and financing and investing activities. It consists of three parts.
These include net cash flows from:
Operating activities (net profit plus depreciation minus increase in net working capital
minus interest and direct taxes paid)
Investing activities (sale purchase of fixed assets and investments, loans to/from
subsidiaries and investment income)
Financing activities (issue of equity/preference capital, loans taken/paid back and
dividends)
The cash flow statement could be called a perfect X-ray of the financial transactions
of a company. In other words, that a company churns huge profits does not necessarily
indicate its good health. And it may also not be generating enough cash to service its
shareholders with dividends.
Operational cash flows: Huge profits need not mean good health-they could be blocked
in inventories and receivables, and the company could actually be cash strapped.
Sometimes, companies report higher sales by dumping finished goods to its dealers at
the fag end of the financial year.
Going by the profit and loss account alone, not many would have resisted investing
in the stock. There are several instances where companies report negative cash flow
from operating activities, by artificially raising inventories and other current assets. Cash
generation from operations would be a much better tool if taken as a proportion of its net
sales-the higher the percentage, the better. In other words, a company that generates,
say, Rs 10 crore of cash on sales of Rs 100 crore is much better placed than a company
that generates Rs 5 crore on similar sales.
Investing cash flows: The other important sections consist of cash flow from investing
activities and financing activities. Cash flow from investing activities reflects how the
company has deployed its resources in fixed assets, investments (equity and debt),
loans to/from subsidiary companies as well as receipts in the form of investment income
and sale of fixed assets and investments. Generally, the figure of cash flow from
investing activities is negative; that is, there is usually a cash outflow mainly on account
CHAIRMAN’s SPEECH
This is where the “vision thing” happens. The Chairman’s speech should ideally
reflect actions and plans for the future. The chairman talks about the general direction of
the company and the industry, sometimes the economy. He usually makes this speech
at the company’s annual general meeting, which is often published as an advertisement
in newspapers and magazines. Sometimes, they provide the occasional insight.
AUDITOR’s REPORT
This can be most boring part of an annual report. In most cases it will merely
state that the profit and loss account and balance sheet give a true and fair view. But it
can also tell us if the management is up to any unacceptable or unethical accounting
practices.
Sometimes, companies do not make provisions for certain exigencies.
Sometimes, the companies change accounting policies, which make comparison with
prior period performance less meaningful.
MISCELLANEOUS INFORMATION
Apart from the above details, companies can also provide a host of other information
that can influence one’s investment decision. These include number of employees,
shareholding pattern, risk management and market information.
Risk Management: Infosys Technologies’ annual report lays out the perceived risks the
company is facing and how the management plans to tackle them. Such openness has
helped it get a superior discounting, even to other high-performance software stocks.
Market information: This includes stock exchange information such as book closure
date, record date for dividend, percentage of shares already under demat, price
performance of shares listed outside India (like GDR and ADR).
Annexure to the directors’ report: It tells, among other things, us about the salaries the
company’s executives are being paid.
FINANCIAL SUMMARY
This includes the company’s long term past performance.
Fundamental data: Many companies give financial data for the past 10 years. Things
covered under this include equity capital, net worth, sales, EPS, dividend, book value,
etc. But, some companies give info about for five years only.
Technical data: Some companies even give share price data for the past one year.