Five things to look at when reading annual reports

The annual report that lands on every shareholder´s table does not always get the attention it deserves. However, it is one of the most authentic and detailed sources of data when researching a company stock. It reveals a lot about the company - from its corporate information to its financial status, cash flow situation, debts, profits, ongoing legal cases and future plans. The report is also first-hand information, so the investor does not have to depend only on secondary sources such as market news and analyst reports. 

Although annual reports may vary, below are five things that should be checked by all investors.

1. Transparency

Management should be transparent in their reporting to owners, during good times and bad. Being transparent means reporting the essential information that the public needs to understand the business, its risks and to value the company. For instance, if a company that has been communicating openly, changes its style and becomes less transparent, this should raise a red flag. 

Transparent reporting is also good use of management time, as it should reduce the need for face-to-face meetings with shareholders and thereby letting managers focus on what matters most - managing shareholders’ capital well by running the business well. 

2. Clarity

Reporting should be clear so that shareholders can understand it. Unclear reporting, such as twaddling explanations or clashing text and numbers, must be avoided and could even indicate that management is trying to hide something.

3. Trustworthiness

Valuation is about applying equations to data. It is important that data are correctly presented, and this means one must be critical of accounting methods. Be careful around companies that use aggressive accounting. For instance, a large increase in receivables, cost deferrals and declining depreciation rates could indicate trouble ahead.  

4. Cash flow and debt

Discount free cash flow, not dreams. So, be sure to focus your analysis on facts and the company’s ability to pay future obligations. Income is not always the same as cash flow, let alone free cash flow. And at the end of the day, it is with free cash flow that future obligations are paid.

5. The fine print

In some ways, reports can resemble advertisements. The glossy portion of the ad is devoted to reasons why you need an amazing product while the small print depicts the pain that may await if you use it.

So, don’t assume anything and always read the fine print as the devil might be in the detail.