Understanding annual reports

A few words from the auditor and chairman can be revealing.
By Stuart Wilson, Australian Shareholders' Association

It is a sad fact that most retail shareholders do not bother to read the annual reports of companies they own. If you challenge yourself to track down the electronic version of the annual report or request a hard copy from the company, you will be ahead of the majority of your peers in the marketplace.


It is the single most illuminating document you are entitled to each year and goes a long way to helping you understand the business in which you are a part owner.


Get in the habit of reading annual reports, not only of the companies you invest in but also competitors and other potential investments. The annual report is a goldmine of information and the nuggets you uncover could make, or save, you a small fortune over time.


Start with the audit certificate


When you open the report, first make sure the figures in it provide a true and fair view - you want to see that the auditor has no issues.


Many companies have an additional paragraph or two attached to their audit certificates. The 'emphasis of matter' is a way the auditor can draw your attention to an issue facing the company without qualifying the accounts. The main issue will relate to 'going concern', which usually means the auditor sees some uncertainty surrounding the company's ability to roll over bank debt.


Keeping the audit statement in mind, next delve into the actual accounts - income statement, balance sheet, statement of cash flows, and notes to the accounts.


Educate yourself on company analysis


If you are not in the business of accounting or investment, it is essential that you invest some time in educating yourself. Interpreting the results, performing ratio analysis and forecasting are all essential activities that make up the analysis of any company. The ASX website and the ASA education program are great places to start for the basics.


Look closely at debt


It would be neglectful not to take a close look at companies' debt positions at June 30. Excessive, or even only moderately high levels of debt, will require companies to explain their positions on interest cover and their relationship with their bankers.


Debt covenants are also in the spotlight this year. These are essentially trigger points at which a bank can call in loans. Covenants can be based on profitability, market capitalisation or asset values, or some other measure or event. Check the notes to the accounts to see if the company was in breach of any covenants. It is a huge warning signal.


Debt concerns have also left companies wanting to boost their balance sheets. Investors in the past 18 months or so have become jittery over companies with relatively high gearing ratios; and asset values have fallen, compounding the problem.


Valuations accountability


When asset values are rising, company management is content. When they are falling, usually the company blames the way the accounting standards require value to be measured, rather than admitting a substantive loss in value. If you read this type of obfuscation, question management's ability to hold themselves accountable and take responsibility.


Property valuations also have been slashed during this year's confession season. However, some have been less cut-throat than others. In particular, expect to see extra explanation and commentary on valuations that have been performed by directors, even down to the assumptions that have been used.


If these are not present, it is a signal that shareholders and analysts might not have the same rosy view as the directors.


Companies that have been on the expansion trail may incur write-downs in the value of intangible assets as they face up to the fact that they overpaid for businesses purchased during the past couple of years.


Governance and remuneration


Do not skip the corporate governance statement. It may look similar year after year but it should not be. Expect to see improvements in the way companies describe share trading policies, the approach to risk management and a tightening of remuneration practices this year.


Companies operate on an 'if not, why' regime for this report. If a company does not comply with best practice it must provide an explanation as to why. Carefully, even cynically, assess their reasoning and factor it into the overall risks associated with the company.


The way the senior executive team is remunerated can often have a huge effect on their decision-making. The remuneration report is mandatory reading because it indicates the amount of backbone the board of directors have (as reflected in pay restraint or otherwise). If pay is predominantly short-term in nature, or has performance hurdles that are easy to clear, this can ring alarm bells for long-term investors.


Looking back, going forward


The annual report is a review of the prior year, but for some time it has also been used to provide guidance on what the company expects to see over the next 12 months and beyond. Best-practice annual reports show the key performance indicators (KPIs) for the prior year, how the company performed relative to each KPI, and the KPIs for the next period.


Motherhood statements espousing quiet confidence in a period of uncertainty belie a lack of conviction on the part of management.


A key word from the chairman


The chairman's address is usually worth reading to find the word or phrase that has been used to describe the prior year's profit performance. Keep in mind that the spin doctors have often had their turn at wordsmithing in order to euphemise bad results.


Rest assured that if the chairman describes the result as terrific, excellent or stellar, it is likely that profits reached or exceeded optimistic forecasts.


Last reporting season saw the primary use of three adjectives - strong, solid and sound. Indeed, most of the 20 largest listed companies adopted one of the three words. They describe profits that were hard earned, by no means stellar, and possibly disappointing.


Watch out for words that sugar-coat terrible results, such as satisfactory or (worse still) mixed. It is an indication of how upfront the company's stewards are with their owners and how willing they are to take responsibility for the results.


So-called 'underlying profit'


Nothing beats the audited accounts as a starting point. You may want to make adjustments to earnings in order to better reflect the underlying performance of the business, but it is better that you do it rather than rely on the so-called 'underlying earnings/profits' provided by the company.


Underlying earnings or profits will be popular this year as some companies fail to resist the urge to dress up their results. Before relying on them, make sure they are treated consistently in prior years, they are fully reconciled to the actual result, and are not simply EBATB (Earnings Before All Things Bad).


I like pictures and graphs - my eyes are drawn to them. But I don't let this very human trait get in the way of my critical assessment of long-term company performance. When reviewing graphs, ask yourself why the particular metrics were selected and how appropriate they are. Have they been carefully selected to put the company in a positive light? Are there any graphs conspicuous in their absence (such as audited earnings per share)?