The Study of Stock Market through Fundamental Analysis

Lesson -> Annual Report of a company- How to read it?

3.1 What exactly is an Annual Report?

The company's annual report (AR), is a publication that is published every year and sent to shareholders and other interested parties. The annual report is published at the end of each Financial Year. All data in the report are dated to 31 March. You can find the AR on the company's website in the investor's section as a PDF file or you can contact the company for a hard copy.

Everything in the AR of the company is considered official since it is part of the annual report. Any misrepresentation in the annual reports can be used against the company. AR includes the auditor's certifications (signed, dated, and sealed), which certify the integrity of financial data in the annual reports.

The primary audience for the annual reports is potential investors and current shareholders. Investors should be able to access the most relevant information and hear the main message in annual reports. Investors should have the option of requesting information only from the annual reports. Although many websites claim to provide financial information about a company, investors should not rely on such sites. The information will be more reliable if it is directly obtained from the annual report.

You may be wondering why the media website would misrepresent company information. They may not have done it intentionally, but they might be forced to because of other factors. The company might want to include "depreciation" in its expense side of P&L. However, the media site may prefer to add it under a separate heading. Although it would not affect the overall numbers, this can disrupt the overall sequence of data.

3.2 What should you look for in an Annual Report

There are many sections in the annual report that provide useful information about the company. The annual report contains many sections that provide useful information about the company. However, it is important to keep in mind the delicate line between facts and marketing content.

Let's take a look at what the company is trying to communicate through AR in various sections of annual reports. To illustrate, I have taken Amara Raja Batteries Limited's Annual Report for the Financial Year 2013-2014. Amara Raja Batteries Limited is a manufacturer of industrial and automobile batteries.

This chapter is intended to provide a quick overview of how to read annual reports. It is impossible to go through all pages of an AR. However, I would love to give you insight into how I would read through an AR. I will also share my thoughts on what information I can ignore and what information is necessary.

You can better understand the ARBL Annual Report by downloading it and reading it as we move through this chapter.

ARBL's annual reports contain the following 9 sections

  • Financial Highlights
  • The Management Statement
  • Management Discussion & Analysis
  • 10-year Financial highlights
  • Information for corporations
  • Director's Report
  • Corporate Governance Report
  • Section Financial
  • Notice

Not all annual reports are created equal. Each one is tailored to the company's needs and the industry in which they work. Nevertheless, there are some sections that are the same across all annual reports.

ARBL's AR section 1 is the Financial Highlights. Financial Highlights gives you a bird's-eye view of the company's financial results for the past year. . This section may include data in the form either of a table or a graphic display. This section usually presents a multi-year comparison between the business and operating metrics.

The Financial Highlights section contains extracts from the company's financial statements. The company can include some financial ratios that it has calculated. This section is brief enough to give me an overview, but it's not something I enjoy spending too much time on. This section is brief because I could calculate these and other ratios by myself. I also gain a greater understanding of the company and its numbers. We will learn how to understand and read the company's financial statements as well as how to calculate its financial ratios over the next few chapters.

The following two sections (i.e. The 'Management Statement" and "Management Discussion & Analysis', are quite important. These sections are worth my time. These sections will give you an idea of the management's views on the business and the industry as a whole. Each word in these sections is crucial for investors or potential investors in the company. These two sections contain details about the 'Qualitative aspect', as discussed in chapter 2.

The 'Management Statement', also known as the Chairman's message, gives investors a view of the thinking behind the business. This section is often broad-based and provides a view of the business's positioning. This section makes me wonder how realistic the management seems to be. I want to know if the management is able to get the company off the ground. I am also interested in how transparent they are when discussing the good and bad.

The message that the chairman sent to a well-established tea company was one example I clearly remember. The chairman spoke of revenue growth of almost 10% in his message. The company's historical revenue numbers indicated that revenue increased by between 4-5%. In this context, a 10% growth rate seemed like a divine move. This indicated that the man at the top might not be in tune with reality. I decided not to invest in the company. If I look back, it was probably the right decision.

This is Amara Raja Batteries Limited. I have highlighted one section that I find interesting. I encourage you to go through the entire Annual Report.

You can now access the "Next Section".Management Discussion & Analysis", " or "MD&A". This section, in my opinion, is the most important in all of AR. Any company can start this section if they are interested in discussing macro trends within the economy. They also discuss the overall economic activity of the country and corporate sentiment. They may even discuss global economic and business sentiment if the company is highly export-oriented.

ARBL is both interested in domestic and export business. Therefore, they discuss both of these aspects in their AR. 

Take a look at the below snapshot:

ARBL's perspective on India's economy

The companies then discuss industry trends and their expectations for the coming year. This section is crucial as it allows us to understand the company's views on the opportunities and threats in the industry. To find out if the company is ahead of its peers, I will read this section and then compare it to others.

If Amara Raja Batteries Limited is of interest to you, I would go through the AR and see what Exide Batteries Limited has written in their AR.

The Management Discussion & Analysis discussion is broad-based and general. It covers the global economy, domestic economy, and industry trends. The company will discuss other aspects of its business in the future. The report discusses how the business performed in different divisions and how it compares to previous years. In fact, the company gives specific numbers in this section.

Here's a quick snapshot of the same.

Many companies discuss their strategies and guidelines for the coming year across all verticals.

 Take a look at this snapshot:

These were discussed in 'Management Discussion & Analysis. The annual report also includes a number of reports, such as the Human Resources report, R&D, and Technology report. Each report is relevant to the specific industry that the company operates within. If I was looking through an annual report for a manufacturing company, I would be interested in the human resource report to see if there are any labour problems. It is possible for the factory to be shut down if there are signs of serious labour problems. This would not be good news for shareholders.

3.3 - Financial Statements

The last section of the AR includes the financial statements for the company. The financial statements are, as you can see, one of the most important aspects in an Annual Report. The company will present three financial statements:

  1. The Profit and Loss Statement
  2. The Balance Sheet
  3. The cash flow statement

In the following chapters, we will be able to explain each one in greater detail. It is important to note that financial statements can be presented in two formats at this stage.

  1. A standalone financial statement, or just numbers.
  2. Consolidated financial statements or just consolidated numbers

Understanding the structure of a company is necessary to distinguish between standalone and combined numbers.

A well-established company will usually have many subsidiaries. These companies can also be holding companies for many other established companies. This is why I am using the CRISIL Limited shareholding structure to help me understand it better. The CRISIL annual report provides the same information. CRISIL, an Indian company that focuses on corporate credit rating services, is a good example of this.

As you can see, the shareholding structure is as follows:

  1. Standard & Poor's (S&P), a US-based rating agency, holds a 51% share in CRISIL. S&P is therefore the 'Holding Company' or 'Promoter" of CRISIL.
  2. The remaining 49% of CRISIL shares are held by public and other financial institutions.
  3. S&P is a 100% subsidiary of 'The McGraw-Hill Companies.
    1. McGraw Hill now owns S&P in its entirety, while S&P holds 51% of CRISIL.
  4. CRISIL also owns 100% of a company called "Irevna" and holds the remaining 50%.

This hypothetical scenario is a way to keep the above in mind. Let's say CRISIL loses Rs.1000 crores in 2014 while Irevna, its 100% subsidiary, makes a profit of Rs.700 crores. What would you say the overall profitability of CRISIL is?

This is very simple. CRISIL made a loss in its own right of Rs.1000 crs. However, its subsidiary Irevna made profits of Rs.700 crs. Therefore, the CRISIL P&L is (Rs.1000 Cros) + Rs.700cros = (Rs.300cros).

CRISIL's loss has been reduced to Rs.300 crores by its subsidiary instead of the huge loss of Rs.1000 crores. You can also look at CRISIL as a standalone basis suffered a loss of Rs.1000 Crs but was able to recover the difference by submitting consolidated suffered a loss of Rs.300 Crs.

Standalone Financial statements are therefore the company's financials alone and exclude its subsidiaries. The consolidated numbers, however, include both the companies (i.e. standalone financials), and their subsidiary's financial statements.

Personally, I prefer to see the consolidated financial statements for a better representation of the company's financial position.

3.4 - The Schedules for Financial Statements

When a company reports its financial statements they typically report the entire statement and follow up with a detailed explanation.

Take a look at this snapshot of ARBL's financial statements (balance sheets):

The line item refers to each individual in the financial statement. The share capital, as indicated by the green arrow, is the first line item on the Balance Sheet. You will notice that there is a note number associated to share capital. These are the 'Schedules’ that relate to the financial statement. ARBL claims that its share capital is Rs.17.081 crores or Rs.170.81 million. As an investor, it would be interesting to know how ARBL came up with Rs.17.081 Cros for their share capital. This information can be found in the attached schedule (note number 2). Take a look at the below snapshot:

You may not be familiar with financial statements. Jargon such as share capital is understandable. The financial statements are easy to understand. In the next few chapters, you'll learn how to read and understand financial statements. For now, the main financial statement provides a summary. The schedules provide details about each line item.

To Summerize

  1. An annual report (AR) is a communication that a company sends to investors and other stakeholders.
  2. AR is the best way to find information about a company. Investors should use AR to obtain company-related information.
  3. There are many sections to the AR, each highlighting a different aspect of the business.
  4. AR is also a great source of information about the company's qualitative aspects.
  5. One of the most important sections of the AR is the management discussion and analysis. This section provides the management's view on the country's economy and their outlook on the industry in which they work for the past year (what went well and what went wrong) and what they see for the future.
  6. The AR includes three financial statements: Profit & Loss Statement and Balance Sheet.
  7. The financial statements of the company are not included in the standalone statement. The consolidated numbers include the financial information of the company as well as its subsidiaries.