Reading an Annual Report
Without a doubt, annual reports are at the pinnacle of corporate communication. The point of the annual report is to provide a summary of exactly how a company has performed in the preceding year, and to provide a glimpse of the future. Building a compelling annual report is a real art and science, and more than a few consulting firms are doing very well, thank you, by hiring themselves out to create reports for all kinds of companies.
Annual reports are generally written for shareholders and other investors, although they are also required reading for lenders, banks, potential employees, and MBA students working their way through grueling accounting and finance classes. For the most part, annual reports are produced by public, not privately held, companies. Chances are, you won't see a private company's annual financial statements unless you're an owner. For most of the public, the annual report contains the only financial documents they are likely to see. It is, therefore, the best source of information for most people to determine the financial health of a company and to learn of any potential problems or opportunities.
Reading an annual report can be a daunting prospect if you don't know exactly what you are looking for and where to find it. The good news, however, is that most reports are now standardized around a common model of nine key parts, making it easy to review any company's annual report once you get the hang of it.
The final format of the annual report depends on the needs of a company, its industry, and any legal disclosure requirements. Regardless, an annual report contains a selection of the following nine parts:
- Letter from the chairman: The letter from the chairman of the board is the traditional place for a company's top management team to tell you what a great job it did during the preceding year and to lay out the company's goals and strategies for the future. It's also a great place to find apologies for problems that occurred during the year, which may or may not have been solved. Oops!
- Sales and marketing: This section contains complete information about a company's products and services, as well as descriptions of its major divisions and groups and what they do. By reading this section, you should be able to figure out which products are most important to a company and which divisions or groups are most critical to a company's success.
- Ten-year summary of financial results: Assuming that a company is at least ten years old, many annual reports contain a presentation of financial results over that period of time. This is a terrific place to look for trends in growth (or non-growth) of revenues and profit and other leading indicators of a company's financial success.
- Management discussion and analysis: This is the place where a company's management has the opportunity to present a candid discussion of significant financial trends within the company over the past couple years.
- Letter of CPA opinion: To be considered reliable, a company's financial statements have to be reviewed and audited for accuracy by a qualified Certified Public Accountant (CPA). In this letter, a CPA firm states any qualifications that it has with the financial statements. These statements can have great bearing on the reliability of the data or of management's assessment of it.
- Financial statements: Financial statements are the bread and butter of the annual report. This is where a company presents its financial performance data for all to see. At minimum, expect to see an income statement, a balance sheet, and a cash flow statement. Be sure to watch for footnotes to the financial statements and read them carefully. You can often find valuable information about an organization's structure and financial status that has not been publicized elsewhere in the report. For example, you may notice information on a management reorganization or details on a bad debt that was written off by the company.
- Subsidiaries, brands, and addresses: Here you find listings of company locations — domestic and foreign — and contact information, as well as brand names and product lines.
- List of directors and officers: Corporations typically have boards of directors — senior businesspeople from both inside and outside the organization — to help guide them and provide a broader view of markets and business environments than that seen by internal managers. Officers include the president, chief executive officer (CEO), vice presidents, chief financial officer (CFO), and so forth.
- Stock price history: This section gives a brief history of stock prices and dividends, showing upward and downward trends over time. Included is information on a company's stock symbol and the listing stock exchange, for example, the New York Stock Exchange or NASDAQ.
Annual reports are the best tool that the public has to review the performance of companies. And most annual reports contain lots of useful information — information that you can analyze to get a sense of the near- and long-term health of the firm. The more often you read annual reports, the better you'll get at it.
So now that you have all this terrific information, what should you do with it? Here are some definite musts when it comes to reading an annual report:
- Review the company's financial statements and look for trends in profitability, growth, stability, and dividends.
- Read the report thoroughly to pick out hints that the company is poised for explosive growth — or on the brink of disaster. Places to look closely for such hints include the letter from the chairman, the sales and marketing section of the annual report, and management discussion and analysis. Of course, it also pays to keep an eye on the company through the business press or analyst reports.
- Carefully read the letter of CPA opinion to be sure that the firm agrees that the financial statements are an accurate portrayal of the company's financial reality.
- Carefully read any footnotes to the financial statements. These footnotes often contain information about company assumptions that can be critical to a full understanding of the financial statements.