An Annual Report is a mandatory corporate document that outlines, breaks down and reflects the company’s financial position and operational activities for the previous financial year. It gives shareholders an insight into the management actions and how the company is performing in line with the strategy set out by the leadership team.

What is the purpose of the Annual Report?

The annual report is a crucial document that allows shareholders to understand how management has been utilising their invested capital. It is the primary means through which management communicates its activities to shareholders. It encompasses information on financial activities, financial strength, risks, operational activities, and results over the last financial year.

I read annual reports of the company I’m looking at and I read the annual reports of the competitors – that is the main source of material.

Warren Buffett

An annual report contains a wide range of information beyond just financial statements. Analysing each of these key areas can provide investors with valuable insights into a business, its operations, financial position, and leadership team.

The information presented in an annual report varies based on the company, type of management, transparency in reporting, geographical location, and business size.

Some key areas within a report include:

• General business summary (description of what the business does)
• Executive summary message to shareholders (typically from the CEO and Chairman)
• Key financial and operational highlights
• Visual aids such as graphics, images, and graphs highlighting achievements
• MD&A (Management Discussion and Analysis)
• Directors’ report and remuneration
• Financial statements (income statement, balance sheet, and cash flow statement)
• Auditor’s letter and report
• Summary of financial position
• Notes to financial statements
• Accounting policies
• Shareholder pattern and top 20 holders
• Various key disclosures

The purpose of the annual report is to communicate all the previous year’s activities to the owners. While not all areas are compulsory to report, the rise of CSR (Corporate Social Responsibility) means that shareholders favour honest and transparent management reporting. By reporting non-compulsory activities and providing a comprehensive view of all activities, not just the headline-grabbing ones, management can align itself with shareholders and demonstrate strong leadership.

Why is the Annual Report important for Investors?

As an investor, it is crucial to examine a company’s performance and activity before deciding to invest in it. Reviewing the Annual Report, along with other important information released by the company, is essential for understanding how the company is faring. Each piece of information released from the company is critical for analysis.

Without these details, it would be challenging to assess the business’s activities and determine whether it presents a viable investment opportunity. Investors can not only evaluate the company’s past performance but also understand its future strategies.

If you get interested in a company and you read the annual report you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street.

Jim Rogers

When considering a new investment, my initial step is to review the past three years of annual reports. If the company has undergone a significant shift in its operations, I extend the review to five years. Although reports may be lengthy, after reading a few of them, I gain a clear understanding of the business, its financial standing, and operational activities.

After reading the annual report, it often prompts further questions for analysis and guides my additional research into the business. I can swiftly scan through an annual report and decide against investing in a company purely based on the information it provides. Therefore, to me, the annual report is the most critical piece of information that investors should prioritise reading.

Many investors tend to skip the annual report because it can be lengthy, dull, and challenging to decipher. However, no other source of information can replace or provide as much valuable insight into a business as the annual report.

How to read the Annual Report?

It’s helpful to read an Annual Report from start to finish initially. However, for subsequent reports, try reading it backwards, starting with the key critical information and working your way to the top.

The most important details are often buried deep within the report, such as in the notes to financial statements or reconciliation of accounts. Glossy highlights are usually at the front, painting an optimistic picture, while a more pessimistic view is often found at the bottom.

If you’re new to reading annual reports, take your time. Read from the first page to the last, take notes, and highlight areas you don’t understand.

When reading an Annual Report, try to gain an understanding of how the business has performed and how it’s expected to perform in the future, History doesn’t repeat itself, but it often rhymes. When reading an Annual Report, you are trying to answer a variety of questions, such as:

• How has the management executed the strategy?
• Are the management aligned with shareholders?
• How has the business performed?
• Will it perform better in the future?
• What is the current financial position of the business?
• Are there risks to be wary of?
• What do the numbers tell us about this business?

Keep in mind that the annual report is based on historical performance, which can help in painting a picture of the company’s future. However, predicting the future is not easy, and the clues to how a company will perform are often buried in the Annual Report.

The more reports you read, the better at connecting the dots you become. It becomes faster, you can sift key information more efficiently and you start to understand the language. You know when things don’t stack up, you can spot opportunities, and become more effective in your overall analysis.

Geographical differences in Annual Reports.

As a global investor, it’s important to recognise that annual reports vary across different countries. Accounting methods, report contents, and reporting requirements differ, and it’s essential to understand these discrepancies from an analysis perspective.

Reporting requirements vary across exchanges and regions and investors need to know what they are dealing with, especially in areas with less stringent regulatory compliance. Each country will operate with an independent commission such as the SEC (Securities and Exchange Commission), ASIC (Australian Securities and Investments Commission), or the ESMA (European Securities and Markets Authority).

Differences in accounting methods and requirements, such as the US GAAP or the IFRS (International Financial Reporting Standards), create challenges in valuation and modelling work. Various accounting standards use different methods, making it impossible to use a single model that encompasses them all.

The quality of reporting, both compulsory and non-compulsory, may also differ.

As a global investor who operates across Asia, the US, and Europe on different exchanges, it’s important to understand the key differences. For example, in the US, a Director’s Report is separate from the annual report and is called a Proxy Statement, while in other countries, the Director’s Report is included in the Annual Report. Some countries have quarterly unaudited reports, while others have quarterly audited cash flow accounts.

Investors need to comprehend the geographical differences in accounting methods, the various reports required by the country and exchange, and the regulatory body under which the company falls. Once these aspects are understood, investors can determine which reports are essential, how the reporting is structured, and the accounting standards to follow in order to model and evaluate the company effectively.

Conduct background research into the industry.

I’ve found that conducting some pre-reading into the industry in which the company operates is helpful when interpreting the annual report. It’s important to gain an understanding of the macro factors that impact the business, the current stage of the cycle, and any industry trends and red flags.

Investors should understand the current environment, all the players in it, and the future of the industry. Doing some background research prior to reading an annual report will put the numbers and business model into perspective. This approach has helped me in many ways. It can also help to compare what management is planning within the context of the bigger picture.

For example, is the management overly optimistic when the overall industry is in decline? Or perhaps the industry is booming, but your company is reporting pessimistic results. Analysing a company should be done in conjunction with how the company is positioned within an industry.

Look at the financial statements in the Annual Report.

At the core of the Annual Report lies the Audited Financial Statements. We won’t spend much time here as we have already broken down each financial statement | Income Statement | Balance Sheet | Cash Flow Statement. An investor needs to understand each of the statements, the key Investment Ratios that relate to them, the red flags to look for and the opportunities that may be present.

The financial statements is the area that requires the most time to study. This is where the opportunity or the risk is often discovered. Once you understand each statement and how the Financial Statements are linked, it makes it quite easy to flow through the report, look at each line item, and interpret the results.

A few things I am always looking for when analysing the three statements are:

• Is revenue converting to cash receipts on the cash flow statement?
• Gross Margins healthy and consistent?
• Is revenue rising or declining?
• Is operating margins consistent, high and improving?
• Has the company got more current assets than debt?
• Will the business be able to service all current liabilities with ease?
• Is the company profitable and growing its bottom line?
• Are retained earnings rising and positive?
• Understand the working capital of the business and operational activity.
• Is the investing activity a sign of prudent management?
• How has the company been financing activity on the cash flow statement?

Once I have analysed all these numbers and key ratios, I will run a comparison to previous years to see how a company is tracking.

Everything an investor needs is within the report and financial statements. All the information is there, the challenge is for investors to interpret the numbers to reinforce whether it is a good investment opportunity based on these reasons or not based on these reasons.

Some of the key Annual Report areas to focus on.

Now that we’ve gone through the basics of the annual report, let’s look at some areas I believe to be important. Each section will provide insight into the business. There will be small nuances in each component. Our job as investors is not to jump to conclusions. While some red flags may be cause for concern, nothing should be analysed without first understanding in detail the cause of it.

Most red flags are warranted causes of concern, some are simple hiccups that occur in every business. Some issues are forgivable, and some are not. When reading the annual report in conjunction with quarterly earnings calls and all the other announcements from a company, we begin to see the business in its entirety.

When comparing annual reports over a few years, we are trying to look for certain patterns. These patterns can be in the way the numbers are shown (rising, declining, stagnant, consistent, lumpy) or the way management has delivered what they have said in the years before. I am trying to see signs that the business strategy is being executed in line with what the leadership team have said they would do.

It’s not hard to see if management is delivering. This is not about quarterly earnings calls, which are all short-term noise. This is about the long-term guidance of the business.

When I look back 5 years and the annual report outlined a plan, strategy, and some milestones, then this becomes the measurement of success. If they hit it great, what’s next? If they didn’t deliver, then why? What got in the way? The annual report will shed light on all this information.

In no particular order, here are the areas I found to offer the most insights into a company.

Notes to the Financial Statements.

The notes to the financial statements are the most critical place to start when analysing the financial statements. They break down and provide additional information for all the numbers in the financial statements and are compulsory reading. When you see all those little numbers next to the financial statements and certain line items in a column called “notes,” this is what I am referring to. It will provide context and a deeper understanding of what the numbers mean.

The notes are especially critical when conducting valuation and modelling work. The numbers in the financial statements are just numbers without context unless you understand how they came to be. The notes break down key information such as working capital positions, which shows how working capital is determined and is often the best way to model the business. They also cover areas such as trade receivables, due dates on accounts, debt due, and other financial information important to the position of the business.

The notes cover everything from depreciation to interest rates, covenants of debt, revenue breakdown, as well as the accounting standards used. They also reveal customer concentration risk, which is crucial.

To better understand the three statements, start at the bottom of the annual report and read the notes first.

Reconciliation of Accounts.

Another area that provides essential information is the Reconciliation of Accounts, also known as the reconciliation report or the reconciliation of Cash Flow from operating activity. Some geographies have broken down the cash flow statement in the same section as the financial statements. However, other geographies have a separate reconciliation report that connects the cash flow statement to the income statement.

As we learned in the cash flow statement blog, there are two methods, Direct and Indirect. The reconciliation of cash flow from operating activity uses the indirect method and breaks down all the activities starting with net income. It will show the depreciation breakdown and other non-cash items and how the cash flow statement numbers were made up.

The cash flow statement will show the line items but to further analyse the business we need to understand all the activities and how cash flowed from each activity. This can help in valuation and modelling work. Remember this when looking at an annual report next time, if you cannot see how the cash flow statement arrived at the numbers, look for the reconciliation of accounts to connect the statements.

Management’s Discussion and Analysis (MD&A).

This section will include the director’s letter and message to shareholders. This section outlines the business’s performance from the management perspective, including what went well, risks or challenges faced, and future plans. It is the first direct communication to shareholders and helps to see how management think and how they have interpreted the past year as well as plans for the future.

The Management Discussion and Analysis (MD&A) is important as it discusses past performance and future guidance for the business. This includes projections, financial estimates, resource needs, and the business’s positioning.

The message to shareholders is crucial to analyse, as it shows whether management is candid, transparent, and honest, addressing failures and taking accountability. The MD&A provides insight into how the management views the business, highlighting risk factors and key indicators.

This section can reveal a lot about how management treats shareholders and can provide insight into the leadership and management style. This section is a must-read to further interpret the rest of the report. It is important to remain independent though on your analysis and not be swayed by what the top brass have outlined.

Directors Remuneration.

The director’s remuneration will summarise the compensation, salary packages, bonuses, shares owned and stock-based compensation of the management team. As we outlined in Analysing Management, this will reveal the alignment with shareholders.

Is management taking the liberty of the business and rewarding themselves at the jeopardy of shareholder value? Is compensation far too high in comparison with the industry and other peers? Are they rewarding themselves even if the company is failing to meet its milestones and perform?

The remuneration report is a fantastic place to answer a lot of these questions. I want to see bonuses if any tied to key metrics and not just ones that can be manipulated. Shareholders want to see skin in the game from the team that has been appointed to run the show.  

I want to see remuneration that’s aligned with long-term factors and outcomes. A long-term incentive may be the release of shares after a certain number of years. Long-term options require commitment and performance as opposed to just a high salary.

How is the management incentivised? Find the answers to this question and it will reveal a lot about who sits at the top of the company.

Issuing themselves a lot of shares and diluting others, or heavy salary packages with massive bonuses will all be visible here. Investors need to break apart this section to see whether the interests of shareholders are being protected.

Related Party Transactions.

Investors need to be aware that management may not always act in the best interests of shareholders. Many public companies engage in related-party transactions, which involve dealings among the management team, executives, directors, and affiliated entities.

These transactions can often indicate a conflict of interest and lead to the enrichment of a select few within the company. It’s important for investors to carefully examine these transactions, as they are not always adequately disclosed.

Related-party transactions can include forgiven debts, consulting contracts given to family members, and the use of corporate resources for personal gain. It’s crucial for investors to remain vigilant and scrutinize these transactions to ensure that they are not being used for personal enrichment at the expense of shareholders.

Auditors Report.

The auditor’s report will outline whether a company is compliant based on the accounts management present to them. The report that accompanies financial statements can give some insights into the business and outline some risks or areas that the auditors raised.  

It is an independent review of the company’s financial affairs and is critical to protect shareholders. While the audited financial statements should provide some relief to investors, sometimes it means nothing in terms of quality. We need to still be able to analyse financials ourselves. The audited report is based on what they are presented. An auditor will declare their independence and carry out the report based on what they review.

Whilst the report will shine light on all the areas, I am more concerned with the quality of the auditor, I don’t want there to be some unknown small firm. I want a top 4 or a well-known accounting business always involved. I also look for constant changes in the auditor. This is never a good sign when management keep changing the auditors of a business.

Look for any KAM (Key audit matters) and read the overall summary of the auditor’s report. Areas of concern should be studied closely.

Outlined Risk Factors.

Some geographies like the US include risk factors of the business in the annual report. Whether it is interest rate risk, competitive risk, or economic concerns whatever the risks a company faces it is listed here. Some countries and commissions don’t require this type of reporting.

This is up to the management of the business whether they want to include a list of the key risk factors the business may face. It is always a good sign when management outlines some issues for investors to be mindful of. Always look at the risk factors section if it is available.

If it is not present, you will need to independently conduct your risk assessment which will always be included in your investment thesis. The risk factors could be generic such as market and economic or it could be serious such as the rise of a competitor, a change in legislation, product issues or business headwinds.

Investors should spend just as much time understanding the risks that may derail a business as well as the opportunity that will make a business.

Revenue Recognition.

It’s essential to consider the section that depends on the company’s geographical location and whether it is reported at the beginning of the annual report, in the initial highlights, or in the financial statements. Sometimes, this information can be found in the notes to the financial statements.

This is important because it breaks down how the company classifies its revenue. It is usually related to the accrual accounting method, and investors need to understand how a company records revenue. Does the company record revenue and recognise it when a product is delivered to a customer without receiving cash? Or when an order is initially made without the exchange of anything? Some companies have been known for “aggressive revenue recognition,” and this section may help to identify these issues.

We need to understand how transactions are recorded and what constitutes a sale. Understanding this can provide valuable insights into working capital needs, the cash flow position of the business, and information to help model and value a business.

Investors should know the conditions under which revenue is considered. This will help investors understand the sales cycle of a business as well as the finances a business may need to operate in the short term.

Segment Reporting.

Businesses often generate income from different business divisions across various regions. The segment report provides a breakdown of each segment’s sales and further categorises them by divisions across different countries. This allows creditors, shareholders and management to look at the most important units of the business and areas that may need focus.

This report offers valuable insights into a business’s opportunities, revealing which regions bring in more revenue and which business divisions are performing well or not. It’s important to note that not all revenue is equal, as certain products and services may be more profitable or have larger Total Addressable Markets (TAMs). The segment report assists investors in analysing, modelling, and valuing a business, allowing them to understand how a business generates its revenue.

Furthermore, the report helps identify new opportunities, such as the potential for new products and services or identifying countries that outperform others. It also enables investors to identify any declining divisions. Investors must understand that the financial statements, especially the income statement top line, should never be interpreted in isolation without considering all the different segments that contributed to the overall revenue.

Competitive Landscape and peer analysis.

Sometimes management decides to list their key competitors. This is a fantastic resource as the first step when analysing a potential investment is to also analyse their competitors. Sometimes, they may be the better candidate.

An annual report will usually have this information towards the very end. A list of peers and competitive companies, whether public or private may be listed. This shows what the company may deem as a threat and so we should also take this seriously.

I search for this in the annual report when conducting my initial analysis of a business. If they are public companies, I start my research side by side. Company Comparison is a great way to reveal if a company is doing something above average or whether it is performing in line with or below an industry.

Looking for signs of a better tomorrow…

When analysing an annual report, investors (including myself) are looking for signs of a better tomorrow. If a company is growing and succeeding, will it continue to do so? If a company is struggling, will its future be better than it is today?

There are a lot of subtle pieces of information that provide insights into the outlook of a business. Ask the question: what is management doing to further grow or improve the business?

The message to shareholders and the breakdown of activity can be verified by the financial statements. The investment activities of the management team can be cross-checked with the investing activities in the cash flow statement and the notes.

Are they investing diligently for the future? What are they investing in? What will the result be from this investment, i.e., value creation or destruction?

If management is talking about improving operating efficiency, where are they focusing? Are the operating activities, cost of goods, gross margins, and fixed costs all reflecting the improved operating efficiency?

I find the annual report great at reading what management has done, is doing, and plans to do and then cross-checking this with the numbers (both past and projected). The numbers don’t lie.

Perhaps management is talking about market expansion and new regions. We can study the TAMs and the size of the new market. Perhaps risks will be revealed as other companies may have failed to do the same.

The annual report can help to look at the future of a business and the signs of a better (or worse) tomorrow.

In Summary…

While this may not be a comprehensive guide to reading annual reports, it is a short explanation of how I think about them and what areas I pay attention to. A visual walk-through of a company’s annual report and breakdown may have been helpful. However, it would have been challenging to base the guide on an annual report from one country and have someone read it from another region. I think it would throw investors off by narrowing down on reporting styles.

This is why I believe having a list of areas to observe and key information to look for would be far more beneficial.

If you can keep your eyes peeled for the above key information to study, then it will help to analyse the overall business in greater detail. How the annual report is interpreted will be largely influenced by your investment criteria and philosophy.

I mention this because there is no one way to interpret an annual report. Your investment style will shape the areas of importance that you need to analyse and the results will be based on what you’re looking to do.

This should help investors to know WHERE to look when you want to find certain information and what each section includes.

The information you want to gather may be presented slightly different. However, the meat of what you want will remain the same and is found across the report if you know where to look.

The annual report is the key information that investors need to study to determine whether a company is investable. If you are already invested, the annual report becomes the guide that reinforces your thesis and whether a company remains a position in your portfolio.