How to Read the Annual Report of a Company

Modified on November 1, 2018

“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. The current article of this series focuses on the annual report of companies. This article seeks to describe:

  • The sources for getting the annual report,
  • Understanding various sections of the annual report along with their importance for an investor
  • A guide to understanding the changes in the financial numbers of companies on change in accounting standard from Indian GAAP (IGAAP) to IFRS (Ind AS) and
  • Answers to other important queries asked by investors:
    • Final dividend declared by the board, is unpaid but there is no liability shown in balance sheet (Impact of Ind AS/IFRS)
    • Why are security deposits present in both the asset as well as the liability side of the balance sheet?
    • How should an investor from non-finance background understand the business/accounting language used in the annual reports?

Annual Report

At the end of each financial year, every company is required by law to prepare a report for shareholders, which provides the details of performance of the company over the year. This report is called annual report. Annual report is the single most important source of information for an investor. Importance of annual report to an investor is akin to alphabets for any language or periodic table for Chemistry.

The detailed analysis of any company starts with reading of the annual report of the company. I believe that if an investor does not read annual reports of companies, she would not be able to become a successful investor.

Sources for getting the annual report

An individual investor can get annual reports of any company from multiple sources. These sources are free as well as paid sources.

Free Sources:

Free sources are sufficient for most of the requirements of any individual investor.  Some of the common sources are:

A) Company Website > Investor Section:

This is the most common source and should be the first place to look for information about any company. Many companies provide annual report for almost 10-12 years on their website. Below is the screenshot of investor’s section on website of Larsen & Toubro Ltd, which provides annual reports from 2002 onwards.

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

However, there are many companies, which do not publish annual reports at their websites. For example Mayur Uniquoters Ltd (MUL) does not have links for annual reports at its website:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

Most of the companies, which lack annual reports on their websites, are small-cap and mid-cap companies, which are yet to have an investor friendly interface. As these companies grow in size, they start investing in public relations & investor friendly initiatives and improve significantly in dissemination of information. Therefore, the absence of annual reports on the website should not be seen negatively. It should be accepted merely as a phase in company’s life cycle. There are many other public sources from where we can get the required information. Some of such sources are mentioned below.

B) Stock Exchange Websites:

Stock exchanges are an important source of information distribution for companies. Many stock exchanges around the world host much more information, financial and otherwise, about companies than mere press releases and corporate announcements. In India, Bombay Stock Exchange (BSE www.bseindia.com) is one such stock exchange, which provides annual reports as well as financial results of the companies listed on BSE:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

As we can see above, the annual reports of MUL are available on website of BSE. Therefore, an individual investor can get the annual reports of the companies that do not provide annual reports on their websites, from websites of stock exchanges.

C) Financial Websites:

Many financial websites also provide annual reports of companies. e.g. www.moneycontrol.com. I have provided a screenshot of webpage providing links of annual reports for MUL on website of moneycontrol.com

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

Paid Sources:

The sources mentioned above are free sources available to any investor. Free sources of financial information are sufficient for most of the requirement of individual investors. However, there are many paid sources as well that can provide the annual reports to investors. Some of such sources are:

http://www.reportjunction.com/

http://www.report.capitaline.com/

Understanding the Annual Report

Annual report provides yearly account of performance of a company. We should read the annual report of a company with same vigor be it when analyzing it for investment for the first time or when monitoring it as part of our portfolio. While analyzing companies for first time investment, I prefer reading annual reports going back as far as possible, preferably for last 10 years or more.

Annual report contains financial as well as non-financial information about the company. Both financial and non-financial information are equally important for investors.

Non-financial Information:

A) Communications from Promoters and Senior Management:

Annual report is an yearly occasion when owners/managers communicate with the shareholders and inform them about the vision of the company, its performance during past year, its achievements, hurdles & challenges being faced, steps taken to overcome such hurdles, status of past expansion plans & other projects undertaken by the company etc.

Many promoters take this opportunity very seriously and inform the shareholders about the company and their philosophy in such details that their communications become a collector’s affair. Warren Buffett is one such person. His letters to shareholders of Berkshire Hathaway as part of annual report are read by investors world over.  I would suggest that every person who wishes to be a successful investor in stock market should read all his letters.

The communication of a company’s management to its shareholders is a very important source for judging the status of the company as well as the industry. In fact, whenever I want to know about the status of any industry, I read the annual report of any company belonging to that industry. One reading of management’s communication and the Management Discussion & Analysis (MDA) section would give an investor an authentic brief snapshot about the industry and the company.

B) Directors’ Report:

In this section, the directors as representatives of shareholders intimate them about the financial performance of the company during past year, status of projects under implementation, major customers, status of conversion of new customers, other major initiatives taken by company. We should analyse the current performance of the company by comparing it with the outlook presented by directors in past years in the annual report. Special focus should be on the projects under implementation. We should check whether company is able to finish projects on time and whether the company has abandoned projects midway. I have provided below a snapshot of the director’s report from the FY2013 annual report of MUL.

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

C) Management Discussion & Analysis (MDA):

MDA is another important section where management informs the shareholders about the business environment being faced by the company. The management informs the shareholders about the industry outlook, company outlook, opportunities, challenges, risks, updates on research & development, human resources etc. A snapshot of the MDA from the FY2013 annual report of MUL is provided:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

D) Details of Personnel in-Charge of running the Company:

The annual report provides details qualification of all the directors, key management people responsible for decisions of the company. It provides details of employees who are being paid in excess of Rs. 60 lakh (Rs. 6.0 million) per annum in annexure to director’s report and disclosures. Below screenshot provides details of salaries of most of the directors including promoter-directors of MUL for FY2013:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

We get to know about the salary being drawn by most of promoter directors in this section. We can analyze whether salary drawn is in line with the industry norms/profits of the company.

In case of a company, Ambika Cotton Mills Ltd (ACML), I was surprised to see that the salary being drawn by promoter-chairman & managing director (CMD) was Rs. 75 lakh (Rs. 7.5 million) per annum and the salary of his daughter who was working as executive director was Rs. 1.5 lakh (Rs. 0.15 million) per annum. In FY2013, ACML had reported sales of Rs. 400 crore (Rs. 4,000.0 million) and net profit of Rs. 31 crore (Rs. 310.0 million). Salary being drawn by the promoter’s daughter was mere Rs. 12,500 per month, which is equal to any lowest level employee of any government organization in India. The screenshot from annual report of ACML for FY2013 showing salaries of Mr. Chandran (promoter-CMD) and Ms. Bhavya (his daughter, executive director) is given below:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

E) Report on Corporate Governance:

This section contains the details composition of board of directors, quorum of various committees of the board, attendance record of various directors in different meeting, details of past and upcoming annual general meetings, information of listing on various exchanges, past dividend record, proposed dividend, stock market data, distribution of shares etc. It also contains details of registrar & transfer agent of the company. Following screenshot from 2013 annual report of MUL shows the attendance of composition of board and attendance of directors in last AGM:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

F) Notice of Annual General Meeting (AGM):

This would contain the information about the upcoming AGM as well as different decisions that require shareholder’s ascent by way of a vote. We get to know of salary hike sought by promoter managers, plans of taking further debt, new expansion projects, entry of next generation of leaders in board positions etc by the items listed to be voted in AGM.

Financial Information:

The annual report contains almost entire financial data that an investor needs to form her views about the company:

A) The Independent Auditor’s Report:

The financial section starts with the report of an independent auditor in which an independent entity provides its views about the financial information presented in the annual report. Auditor’s report comments on the key items like any deviation from the accepted accounting practices, any amounts that are not paid to government authorities, any default in payments to lenders, sufficiency of control systems to the size of the company, any frauds conducted by company or its employees, proper utilization of funds raised by company from lenders/IPOs etc.

Auditor’s report gives you a snapshot of authenticity of financial information that follows in the annual report.

B) Financial Statements:

These consist of three important sections: balance sheet, profit and loss statement and cash-flow statement. Financial statements of current year are always shown in parallel to figures of previous year so that performance of current year can be compared with immediately preceding year.

1) Balance Sheet:

This section of financials provides details of all the assets and liabilities of a company at the last date of the financial year. Liabilities are the sources of funds, which a company has utilized to purchase all the assets it owns. Balance sheet of MUL at March 31, 2013 is shown below:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

We can see the comparative position of MUL at March 31, 2013 & March 31, 2012 and observe the way the balance sheet size has increased from Rs. 15,850.16 lakh (Rs. 1.58 billion) to Rs. 21,349.20 lakhs (Rs. 2.13 billion). Almost half of the increase of Rs. 5,499.04 lakhs (Rs. 0.54 billion) has been contributed by increase in reserves & surplus by Rs. 2,700 lakhs (Rs. 0.27 billion). This is a sign of healthy growth by a company.

2) Profit & Loss (P/L) Statement:

This section of financials provides details of total sales that a company has achieved in a year and all the expenses the company has incurred to achieve these sales. The balance after expenses and taxes constitutes the net profit for the shareholders. Given below is the P/L statement of MUL for FY2013:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

We can see that total revenues have grown by 20% from Rs. 31,909.37 lakh (Rs. 3.19 billion) in FY2012 to Rs. 38,327.47 lakh (Rs. 3.83 billion) in FY2013. Such revenue growth is very good. On top of it, we can see that in the same period net profit has grown by 30% from Rs. 3,337.06 lakh (Rs. 0.33 billion) in FY2012 to Rs. 4,362.55 lakh (Rs. 0.44 billion) in FY2013. This higher growth in net profit is an indication of improvement in operating efficiency of the company.

3) Cash-Flow Statement:

This section provides details of the cash that a company has generated in last financial year from operation (cash-flow from operations or CFO). This section also includes details of cash used in making investments or received from selling investments (cash-flow from investing activities or CFI) and cash raised from financial institutions as borrowings or repaid to them during the last year (cash-flow from financing activities or CFF). Given below is the cash-flow statement of MUL for FY2013:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

We can see that in FY2013, MUL generated Rs. 2,723.54 lakh (Rs. 0.27 billion) of cash from operations and raised Rs. 766.70 lakh (Rs. 0.07 billion) of cash from financing and used it for investing Rs. 3,586.26 lakh (Rs. 0.35 billion) in assets of the company. Thus, we can observe that MUL has funded most of its investments in FY2013 from its operations (aka internal accruals), which is a sign of healthy growth.

C) Schedules/Notes to Financial Statements:

Schedules contain the detailed breakup of numbers shown in financial statements. They are an integral part of financial statements and are studied along with financial statements to get better understanding of financial statements. For example, if we want to see the details of long term borrowings in the balance sheet of MUL shown above, we should refer to note/schedule no.5 of the annual report of MUL, for more details:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

Thus we get to know the details of the lenders, their respective loan amounts, repayment schedules and the security offered for different loans availed by company from its lenders.

If we want to see whether MUL has invested in a new plant/assets during the year, then we can see its details in schedule/note on fixed assets:

How to study the annual report of a company understand balance sheet profit and loss cash flow statement management discussion and analysis director's report

We can see that the company has invested Rs. 1,493.94 lakh (Rs. 149.3 million) in current year, which was mainly invested in building & premises and plant & equipment. It indicates that the company is probably investing in a new manufacturing unit. If we see the figures for previous year in the last row, then we realize that last year the company had invested Rs. 1,772.80 lakh (Rs. 177.2 million) in its assets. This gives an investor an indication that the company is in the expansion phase and continuously investing in assets.

Schedules/Notes are very important and should be studied with patience and due care. Quality of schedules is an important reflection of the quality of management of the company. Warren Buffett says that if you are unable to understand the notes, it is because the CEO does not want you to understand them. A lot of information/financial jugglery is often hidden in schedules.

D) Related Party Disclosures:

Every company is required to disclose every transaction it enters into with its promoters and other related entities. A careful analysis of these transactions can reflect whether the promoter is using different transactions to transfer money from the company to itself. We should look at the transactions between company and promoter owned entities (POE, enterprises over which promoters are able to exercise significant influence). Presence of transactions like interest free loans to POE, taking assets owned by POE on lease/purchase at prices higher than market value are some of the examples by which we can get a sense of promoters who are taking out funds from the company and gaining at the cost of minority shareholders.

Thus, we can see that the annual report is one such document that can throw light on the status of the company, provide information to gauge its potential of future growth and provide insight on the character of the management of the company. It is single most important document that every investor should read.

 

Transition of accounting standard from India GAAP (IGAAP) to IFRS (Ind AS);

How to analyse financials upon change from accounting method from Indian GAAP to IFRS (Ind AS)?

Impact of new accounting standard (IFRS) / Ind AS on the financial statements & annual reports prepared under old accounting standard (Indian GAAP, IGAAP)

Hello Dr Vijay Malik,

I was trying to analyze and compare pre- and post-FY2016 financial statements of a company and found many figures different. As I understand, this is because of the change in the accounting standards from previous Indian GAAP to Ind-AS. Therefore, this essentially makes them incomparable.

What is a better way to compare last 5-7 years of financial statements since the standards, and hence figures, have changed? Even financial ratios would be incomparable.

Kindly guide.

Author’s Response:

Hi,

Thanks for writing to us!

Companies provide the reconciliation of change in financial data from GAAP to IFRS in the annual report of the year in which they have started reporting financial data as per IFRS.

For example, if a company has published its financial data as per IFRS in FY2018, then in the FY2018 annual report, it would disclose multiple tables, which will show the numbers as per GAAP in the first column, the changes after adoption of IFRS in the next column and then the final numbers as per IFRS in the last column.

In case of Mahanagar Gas Ltd, when an investor reads the FY2017 annual report, then from page 139 to page 143, the company has detailed the impact of Ind AS on its financials. The company has provided the reconciliation of its financial statements from earlier accounting standards (Indian GAAP) to new accounting standard (Ind AS, IFRS) including the reconciliation for balance sheet (page 140), total equity, profit and loss statement (page 141) and total comprehensive income (page 142).

For example, see the reconciliation of the profit and loss statement of the company under IGAAP and Ind AS for FY2016:

Mahanagar Gas Ltd Impact Of Ind AS On Profit And Loss Statement Financials

Moreover, Mahanagar Gas Ltd has explained the impact of Ind AS on each of the item in the financial statements in the notes under the reconciliation segment. E.g. notes to reconciliation on page 142 of the FY2017 annual report:

Mahanagar Gas Ltd Notes For Reconciliation Of Impact Of Ind AS On Financial Statements

Read: Analysis: Mahanagar Gas Ltd

Therefore, we suggest that investors should read the annual reports in detail to understand the transition of financial data from GAAP to IFRS.

If upon reading the transition data in the annual report, an investor still has some queries, then she should contact the company directly for clarification/additional information about the reconciliation data.

Comparison of the new financial data with the past financial years will differ from case to case. An investor should first understand the transition of financial numbers from GAAP to IFRS for any year by reading the annual report in detail. After looking at the extent of difference in the GAAP and IFRS numbers, investor may herself decide whether the IFRS financial data for the company is comparable with the previous year’s GAAP data. If the differences are small, then investor may continue to use sequential comparison. Otherwise, she may refrain from doing it.

In a nutshell, the essence is to first read the annual report to understand the transition/reconciliation of GAAP and IFRS financial numbers and then decide whether to do the comparison with past years or not.

Now let us understand the other important queries asked by investors, which prove helpful in improving the understanding of annual reports for all the investors:

 

Investors’ Queries: Understanding the Annual Report of Companies

 

Final dividend declared by the board, is unpaid but there is no liability shown in balance sheet (Impact of Ind AS/IFRS)

Dear Sir,

Please refer the following sections from the annual report of a company:

In the cash flow statement, the dividend column is blank in cash flow from financing activities. Therefore, one can assume, they have not issued dividends this year.

However, in the Director’s Report, they have disclosed that the company had declared a dividend:

DIVIDEND

Based on the Company’s performance, the Directors are pleased to recommend for approval of the members a dividend of ₹2.50 per equity share of ₹10.00 each (i.e. 25%) for the financial year 2016-17, to be paid on total equity shares of the Company. The dividend on the equity shares, if approved by the shareholders, may involve an outflow of ₹727.79 Lakh towards dividend and ₹148.16 Lakh towards dividend tax, resulting in a total outflow of ₹875.95 Lakh.

Moreover, many companies do not show any liability of dividend declared by them in the balance sheet.

Whys is it so? Please clarify.

Author’s Response:

Hi,

Thanks for writing to us! It is great that you are reading the annual reports line by line and making insightful observations. Such effort is commendable.

A dividend outflow is shown in the cash flow statement only after the company pays the dividend amount to its shareholders by cheques/DD or by online bank transfers. Until the dividend money goes out from the company, it will not show in the cash flow statement.

Under the previous accounting standards, Indian GAAP (IGAAP), the unpaid dividend amount used to be shown as a current liability by the companies during the period between declaration of the dividend and the actual payment to shareholders. However, since the adoption of new accounting standard based on IFRS (Ind AS), this practice has undergone changes.

As per IndAS, unless a dividend is approved by the shareholders, it cannot be shown under liabilities. In the previous accounting standards, the companies could show dividend under liabilities at March 31, 2017, before the shareholders approved it in the AGMs in July/Sept 2018. However, now the new accounting standards direct that dividend cannot be shown as liability unless shareholders approve it. Therefore, now we do not find any mention of the dividends declared by the board but unapproved by the shareholders, anywhere in the financial statements. Now a day, the annual reports contain information of such dividend declarations in the Directors’ Report only as a paragraph without creating any liability in the balance sheet.

Hope it answers your query.

All the best for your investing journey!

Regards,

Dr Vijay Malik

 

Why are security deposits present in both the asset as well as the liability side of the balance sheet?

Hi Dr Vijay,

I have a doubt regarding a company that I was analysing.

1) In the notes to the financial statements section, there is a note for ‘other long term liability’ under which there is one entry called ‘security deposits’. What is this?

There is another ‘security deposit ‘ in the ‘other non-current assets’ section.

What is the difference between the two?

2) What is the trade receivables for a hospital? How can a hospital give its services to customers (patients) for credit?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

1) Security deposits in the balance sheet:

The deposits that a company has received from its customers/vendors are shown under liabilities.

The deposits that the company has paid to service providers etc. like security deposit paid to the owner of a building, which it has taken on rent for office/factory is shown under assets.

2) A hospital may have trade receivables from insurance companies if the insurance companies take some time for payment to hospital after claim is approved. The hospital may also have receivables if it has a tie up with any corporate for treating their employees. The employees may take treatment today and their employer may settle the bill after some time.

Hope it answers your queries.

All the best for your investing journey!

 

How should an investor from non-finance background understand the business/accounting language used in the annual reports?

Hi Sir,

As per your recommendation, I am reading annual reports of multiple companies. However, I am facing challenge to understand the language. Most of the companies write cooperate language, which I find difficult to understand as I am from science background. Is there any best way to understand the annual reports?

Your suggestions are most welcome.

Regards,

Author’s Response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

The best way to learn about business language is to read many annual reports, which you are already doing. Therefore, you are on the right path. Whenever an investor comes across new terms, then she may use Google/Investopedia etc. to refer to find the descriptions of these terms. Moreover, with time and reading more annual reports, the strange terms will start becoming familiar. As a result, the time to read future annual reports will decrease drastically.

At our website, we have covered many accounting terms in our articles. Therefore, whenever you come across any new terms, then you may use the search feature of our website to see if there is already an article on that term on our website.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

Related Query:

More of a behavioral question. Every day, I try to read about the processes and books related to investing or the blogs. But when it comes to reading the annual report or doing the fundamental analysis of any stock, I somehow lose patience or I find it very boring or I am not able to find it exciting and skip over some sections.

Would be great if you can share if you had similar experiences and how did you overcome that. How do I create the discipline in me? Looking forward to your response

Author’s Response:

Hi,

Thanks for writing to me!

Reading annual report is not a choice but a necessity for any stock investor. An investor needs to understand this fact. If she is not reading annual reports, then knowingly or unknowingly she is hurting her development as an investor.

Regards,

P.S.

Future articles in this series would build upon the understanding of annual report to further the discussion on financial, business & industry, management and valuation analysis of companies. We would learn in detail about the concepts and parameters of such analysis by applying it to analysis of a sample company.

I would be happy to learn about your feedback on this series of articles and your learning from reading of annual reports. You may share your inputs in comments section below.

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