On Reading and Analyzing the Annual Reports

Recently I have taken to reading annual reports of companies - For now, only public Indian companies. My father used to and still trades in stocks and I remember when I was a kid, we used to receive several huge paper reports at the year's end. Now, thanks to increased awareness about climate change, everything is represented in digital formats.

As a kid, my favorite activity was to look at the fancy pictures, cut them off, and glue them in my room. Since I started learning English too late, I couldn't understand a word of it. But it was still fun to look at all the top brass who I knew were the ultimate bosses of the company. Not sure how much anyone got out of those reports at that time, but we definitely made some good money selling those heavy reports as junk paper to local retailers and grocery merchants.

Now that I have grown up and have educated myself a little bit about good companies, stock markets, and returns, I have turned to reading public companies' annual reports during my leisure time. These documents look daunting in the beginning due to the sheer size, but you don't have to read every word of it. Most of the report is templated, and some of the content is repeated due to regulatory standards about how the report should be published.

So how do I read the report? Which things do I pay attention to and which things do I ignore? How do I manage time to read it? How does reading a report change my opinion about the company and ultimately about the investment decision? In this post, I am going to clarify my rationale behind the report reading and how it affects my investment decisions.

Choosing Which Report to Read

There are thousands of companies out there on NSE and BSE. It is virtually impossible for one person to sit and go through all their annual reports. Besides, you won't get much value when you are curious about everything around you. In my opinion, as far as report reading decision is concerned, companies fall into the following brackets,

1. Good companies I haven't invested in, but I still want to
2. Companies I am interested/invested in, but don't have much clue about
3. Companies with an innovative business model
4. Companies I am torn between - On one hand, I want to own the stock, but on the other hand, analysts are raking this company over the coal

For example, companies like Reliance Industries, Tata Motors, TCS, and Tata Coffee are well-known, stable, and have their business models straightforward, so I won't dig much into them. But if I come across less well-known companies or companies that are also doing some interesting stuff, I satisfy my curiosity by reading their reports. This includes Tata Elxsi, Devyani International, Jubilant Food, Thermax, IndiaMart, etc.

Which Content Do I Focus On

There is just too much content in the annual report, so reading it all is not practical. I usually focus on,

1. Company management (Resignations, scandals, unusual departures, scrutiny, compensation, etc.)
2. Has the company suffered from any penalty by the regulatory authority (Imprisonment, fines, lawsuits, etc.)
3. Management discussion and Analysis (Introspection and future outlook)
4. Known risks and risk mitigation strategies
5. Financial statements (Not too deep, but mainly focusing on free cash flow, retained earnings, EBITDA, debt/equity ratio, etc.)
6. Employee development (Training, insurance, parental support, ease of mobility, attrition rate, etc.)
7. Future expansion plans and major collaborations
8. Sustainability approach and renewable energy investments

Which Content Do I Ignore?

I believe SEBI has a pre-defined template for presenting annual reports. No matter what you do, you still have to adhere to it. This includes generic disclosures, legal opinions, annexure, auditors report, notices, e-voting instructions, and disclaimers regarding things out of control of management and the company.

There is also some content that gets repeated on many pages. For example, SEBI might ask companies to provide answers on two issues, but they both have the same answer. In that case, the company still has to publish it twice.

Vague Statements

Sometimes when asked about risk management, profitability of future outlook, the company makes generic statements that have little or no relation to the business. Reports might also be making claims about the popularity of specific products or services, but if you look up online, people aren't really happy about them.

In other cases, customer care of the company is not up to par and people receiving bad products badmouth the company on social media. In such cases, you no longer know which version to believe.

Look for Explanations

Companies might not be too lucky to put everything in place all the time. Sometimes things go wrong. For example, reduced profitability, lawsuits from tax authorities, public scandals, impairment of assets, etc. However, the company is still expected to provide satisfactory reasoning for such circumstances no matter how bitter they are.

As an investor, I would rather be happy to see the company being transparent and providing all the details and reasoning behind unfavorable outcomes or decisions than presenting it as "good" to convince shareholders that it's not as bad as it looks.

Look for Exceptional Items

Exceptional items are those that happen one time in the given financial year. They may significantly affect the profitability or loss. Although financial statements may look worse or better, you might need to check if there are any exceptional items causing it.

Key Audit Matters

Key audit matters are those matters that, in the auditor's professional judgment, were of most significance in the audit of the financial statements. They may be related to asset impairment or tax penalties that might have significantly moved the financial statements.

Summary

No matter how many times you have done it, annual reports are intimidating. They are at least 200 pages long and some can even stretch 550 pages long. Only look at the things that matter to you and focus on them. For example, if the company is already financially strong, you can gloss over its financial statements. If you already know about its operations and business model, you can skip the introductory pages.

Financial statements are one of the worst parts of a report. Unless you're an accountant, a lot of this stuff is not going to make sense to you. But you can still understand, company assets, liability, loans, impairment, profit after tax, tax, exceptional items, etc. These are still good things to know to gauge the company's financial strength.

Hope you liked this post which deviates a lot from my regular iOS articles. Are you an investor and are avid reader of the annual reports? What was your experience like? Are there things you pay attention to or perceive important that went unmentioned in this article? Please share your thoughts with me on LinkedIn.

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