Annual
Reports provide a lot of information to a variety of people. They play an
important role in making investment decisions. We enclose a study of annual
reports and details about what to look for in annual reports.
Annual
reports often conceal more than they reveal. Yet they are perhaps the best way
to tell if the companies you are invested in are up to any good. Annual reports
are designed to satisfy the needs of existing shareholders, potential
shareholders, creditors, economists, financial analysts, suppliers and
customers. Financial statements are the heart of an annual report. Financial
statements include a Balance Sheet, Profit and Loss account, Cash Flow
statement, schedules forming part of the balance sheet and accompanying notes.
Other important sections in an Annual Report include Management Discussion and
Analysis, Chairman’s speech, Directors’ report, Auditors’ report, Corporate
Social Responsibility statement and Report on Corporate Governance and other
shareholder information.
The standard of
disclosures in India
By quantifying the
quality of disclosures, one can assess the performance of companies. Good
companies give valuable information to the shareholders, even though such information
may not be mandatory. For the year 2005-06, many companies have dispatched
their annual reports after the closure of the financial year. (For many
companies in India
When we receive these
reports, we are tempted to put them aside or pass them straight on to a garbage
can. Many investors do not care to leaf through them. If one goes through the
reports, one can have a fair idea about the company’s strengths, weakness,
opportunities and threats, which will enable investors to take informed decisions
about a company’s future performance.
Sometimes, there is no
uniformity in disclosures. For instance, HDFC Bank discloses information on
wholesale banking, retail banking and treasury. In contrast, Canara Bank
discloses information on treasury and banking operations. Infosys discloses
information on various verticals while Satyam does not disclose segment-wise
information. Reliance Industries divulges the free cash flows generated by each
segment. Few big companies disclose free cash flows of each and every segment.
Let us now try to find some key takeaways from
the annual reports:
MANAGEMENT DISCUSSION and ANALYSIS (MDA)
|
In MDA, a company’s
management explains significant changes from year to year in the financial
statements. Although presented in a narrative format, the MDA may also include
charts and graphs highlighting the year-to-year changes. Management gives its
analysis on the past performance and future outlook for the company.
For example, Grasim
Industries had given a detailed examination of the company’s past performance
and future outlook in its 2005-06 Annual Report. The company, in its Annual
Report, revealed that their Cement business had been the key driver of revenues
and earnings, whereas, the VSF and sponge iron business had not done well
during the reporting period. The company is ramping up its capacity by 95 lakh
tones per annum (TPA). The company had identified the following risks that were
affecting the company: Economic risk (through margin pressure), foreign exchange
risk, interest rate risk and commodity price risk. The discussion also outlined
the steps being taken by the company to mitigate these risks.
In the ‘Management
Discussion and Analysis’ section of its 105th Annual Report, the
Management of Indian Hotels outlines an overview of Global Tourism Industry,
Indian Economy & the Tourism Industry, the company’s sources of Competitive
Advantage, opportunities and threats faced by the company and an Update on Key
Initiatives taken by the company to make the best use of the current buoyancy
in Hotels Industry. The analysis lists out major risks and concerns for the
company and the risk mitigation initiatives taken by the company. With the help
of such open discussion about the company’s outlook, scrutiny of a company’s fundamentals and valuation
becomes much easier.
At the end of Management
Discussion and Analysis section, companies usually give a cautionary statement
stating that the statements given may be ‘forward-looking statements’ and
actual results could differ from those expressed in an annual report.
PROFIT AND LOSS ACCOUNT
|
It is a very important
document in an annual report. And it certainly has the most immediate impact on
a stock price. The profit and loss account gives vital information on the
operations, profitability and growth of the company. It summarizes the
financial year’s operations of a business in the bottom line, which after
accounting for every expense could be either a profit or a loss. The important
components are given below.
Total Income: The first item in a
P&L account is sales revenue. It indicates whether or not the company is
growing. If revenues are growing rapidly, it is a clear signal that the company
is doing well. However, this has to be seen in the light of profitability and
efficiency of operations also.
Other income: It is so called because
it does not arise out of the main business of the company; it includes profit
on sale of asset, insurance claims, dividends received from subsidiaries, and
income that cannot be included in sales revenue.
Expenses: Cost of production and
other expenses are detailed here.
Interest: Interest paid on
borrowings is shown here. One has to see whether interest cost is increasing.
In general, when companies are expanding, they show higher interest cost, due
to higher level of borrowings. Interest cost has to be seen in relation to PBIT
(Net profit before Interest).
Interest Coverage
Ratio: A ratio used to determine how easily a company can pay interest on
outstanding debt. The interest cover ratio tells us the safety margin that the
business has in terms of being able to meet its interest obligations. That is,
a high interest cover ratio means that the business is easily able to meet its
interest obligations from profits. Similarly, a low value for the interest
cover ratio means that the business is potentially in danger of not being able
to meet its interest obligations. Interest cover ratio is calculated by
dividing a company’s Profit before interest and tax (PBIT) with interest paid.
For example, the interest
paid by Tata Motors for the year 2005-06 was Rs 293 crore and its PBIT was Rs
2,344 crore, giving an interest cover of eight times, which is considered good.
Whereas Satyam Computers’s interest cover is a staggering 436 (2005-06),
indicating that the interest cost is very low compared to its earning before
interest and taxes. Another extreme case is Hindustan Construction Company,
whose interest cover ratio is just 2.62 (2005-06), which shows that the
company’s ability to meet its obligations is under pressure.
Depreciation: An increase in fixed
assets also raises the depreciation expense. Depreciation is the amount written
off as expenses for the use of the plant and machinery, but it involves no cash
outflow. Over time, due to normal wear and tear the value of a plant/physical
assets depreciates, which if not provided for will skew the true picture of a
company’s financials.
Taxes: Income tax is to be paid
if there is a profit after providing for interest and depreciation. A company
that pays tax can only do that if it has enough cash to meet this expense.
Regular tax outgo is an indication that the company is generating real profits
to give a part to the exchequer. Although there are many factors that make up
stock valuation, a steady tax outflow undoubtedly propels valuations.
Final
appropriations:
The last part of the P&L account depicts how the board of directors
distributes the net profit. First among the items is the dividend to be paid to
shareholders. In fact, one can compare the amount of the total dividend to be
paid with the net profit to give dividend payout ratio (DPR). A high DPR and a
healthy growth in net profits and revenues signifies that the company is in a
healthy financial position.
BALANCE SHEET
|
A Balance Sheet is a
statement of the financial position of a company as on a specific date.
Usually, a Balance Sheet provides information as at the beginning of a
financial year and as at the end of the financial year, so that readers can
analyse the changes that have occurred during the financial year. A balance
sheet is divided into two halves, Asset and Liabilities. In the standard
accounting model, the total of assets is equal to liabilities. As such, both
halves are in balance. They are in balance, because, from an economic point of
view, each rupee of assets must be funded by a rupee of liabilities. Every time
the stock market booms investors flock to it, thinking they can make quick and
easy profits out of the stock market. They just look at the net profit figure
and get impressed by any growth in the net profits. In such situations,
investors ignore the overall financial strength of the company.
One needs to see how the
company made such high profits and how the company uses the resources available
at its disposal. Many a time, investors concern seems limited to profits-not
how they are generated or whether the tempo will be maintained in bad times.
To avoid such mistakes,
one needs to look at the balance sheet. It tells us how a company used its
financial resources in the preceding year. Its study over a period of time
gives enough insights about what lies ahead for the company. Information on a
company’s ability to finance future growth, extent of financial liabilities and
utilization of resources all lie in the balance sheet. These provide insights
about the past functioning of the company and how prepared it is for tough
times-the real test of whether revenues and profits can be sustained. The balance sheet is a record of capital-how
it is raised and deployed. A company can raise money from two sources:
long-term sources or funds that can be repaid over a period, and short-term
sources or funds that have to be repaid within a financial year.
Shareholders’ funds
(equity capital plus reserves) and borrowings are long-term funds. And they are
mainly used to finance fixed assets. Considering the long repayments schedule
these are funds carrying a cost. The cost is in the form of interest (for
lenders) and dividends and capital appreciation (for shareholders). If not
controlled, this cost could play havoc with the fortunes of the company.
Borrowings: Borrowings have a fixed
cost, interest, incurred irrespective of whether revenues increase or decrease.
This is the reason why they need to be controlled. High borrowings in relation
to the shareholders’ funds also deter lenders to provide fresh loans. Let us
say a company has revenues of Rs 100 crore and its material cost is Rs 60
crore, while depreciation stands at Rs 8 crore. If the interest cost is Rs 12
crore, the profit would be Rs 20 crore. If revenues decline by 20 per cent to
Rs 80 crore, the material cost would follow suit and come down to Rs 48 crore,
but depreciation and interest cost would remain at previous levels. Profit
would then be Rs 12 crore, a drop of 40 per cent.
Equity: Many think that this is
free money. Its cost is related to the dividend policy of the company and its
performance, which ultimately tells on the stock price of the company. But many
companies have incessantly raised money from shareholders, arguing that
borrowings would hurt the bottom line. In order to extract the most many wait
for the markets to move up so they can raise fresh equity (through
rights/public issues) at hefty share premiums. ICICI bank and UTI Bank have
raised equity through public issues/GDR in recent years.
Retained
earnings (reserves):
Ideally one should look for companies that manage growth primarily by ploughing
back profits. If reserves are strong they could also be used to retire debt and
reduce the interest burden. Ploughed-back profits are shown as reserves in the
balance sheet and are residual profits after distributing dividends.
Unlike interest cost,
they do not affect profits. At the same time they do not lead to equity
dilution. This money is kept aside to finance the future needs of a business.
Ideally a company should finance it future needs through reserves, unless the
requirement of funds is large enough to necessitate fresh borrowings or
shareholders’ money.
Many companies, in recent
years, have cleaned up their balance sheets through corporate debt
restructuring. For example, companies like, JSW Steel, Essar Steel, etc. had
taken advantage of CDR mechanism offered by creditor banks and brought down
their debt levels considerably.
Current Liabilities: Current liabilities are
short-term funds that cater to the working capital needs of a company. These
funds are in the form of credit purchases and short-term loans, which are extended
by the suppliers.
Current
assets: Working capital or
current assets fund the day-to-day operations of a company. A company cannot
wait for the payment expected in lieu of the goods previously manufactured and
sold. It has to maintain a stock of raw materials and finished goods to ensure
that the production cycle is running continuously. Similarly, credit sales have
to be provided for. Additionally, some cash is required for day-to-day
expenses. Current assets, unlike fixed assets, get converted into cash at
periodic intervals in a financial year.
Fixed Assets: Fixed assets are plant,
machinery and building. By their very nature these are immovable assets with a
long life span. Importantly, they are the revenue-generating assets of a
company. They process the raw material and produce the finished products, which
the company sells and earns a profit from.
Investments: Many companies invest
their surplus funds till they find a suitable use for them. They could then be
invested in either creating more fixed assets or augmenting the working
capital. Sometimes, they go for acquiring other firms within the country or
abroad. Recently, a lot of companies have acquired foreign companies; for
example, Tata Tea, Dr.Reddy’s Labs, Ranbaxy Labs, etc. These assets do earn a
return for the company. These investments could either be in the form of
short-term funds (for example, liquid mutual funds or short-term fixed deposits)
or kept in medium term instruments. But if investments are maintained at a high
level and form a major chunk of the total funds, it is a cause for worry. The
point is that if the core business is not in need of funds and the same
condition is expected to prevail in future, this money can be given back to the
shareholders. It should also be kept in mind what rate of return these
investments are contributing to the balance sheet. Market value of investments of investments
held by such companies as ICICI Bank, IDBI, IFCI, Tata Investment Corporation
and a number of companies and a number of non-banking finance companies is
vital in putting value to their stocks. This information is available only once
a year, making the investment decision a bit tricky. Exide industries had
acquired ING Vysya Life Insurance for Rs 257 crores (at cost) as per 2005-06
balance sheet. Bajaj Auto has an investment of Rs 496 (at cost) crore in ICICI
Bank and Rs 193 crore in its two insurance companies as at the end of March
2006. Its total investment book stands at Rs 5,857 crore as at the end of March
2006.
Human
capital: Another item that finds
a place nowadays in an annual report is human capital. Here, human capital is
not merely one component of capital; it is the critical component that forms
the basis for other forms of capital: People with their expertise are the sole
creators of value to the customer and people through their effort are the key
to the optimization of its process efficiency. Human Capital is defined as the
set of skills which an employee acquires on the job, through training and
experience, and which increases that employee's value in the marketplace. Human
resources valuation has remained an academic exercise and largely ignored even
in industries where the expertise of employees is the key differentiating
factor.
Software major Infosys
Technologies has estimated the value of its human resources of 52,715 employees
including both delivery and support staff at Rs 46,637 crore for fiscal 2006.
This represented a growth of 65 per cent over the previous year's Rs 28,334
crore, when the company had a total headcount of 36,750. The evaluation is
based on the present value of the future earnings of the employees and on the
assumptions of employee compensation including all direct and indirect benefits
earned both in India
CASH FLOW STATEMENT
|
Companies need to deal with various
entities during the course of their business, which may result in financial
transactions. But, to do so, the company needs cash. Hence, it is essential for
companies to improve their respective cash generating abilities. Better
management of these cash inflows and outflows and its respective short and
long-term obligations translate into an impressive cash flow statement.
What is a cash flow
statement? It generally reflects how a company has generated cash during a
given period, in most cases 12 months, and how it has been deployed for its
core operations, and financing and investing activities. It consists of three
parts. These include net cash flows from:
Ø Operating activities (net
profit plus depreciation minus increase in net working capital minus interest
and direct taxes paid)
Ø Investing activities
(sale purchase of fixed assets and investments, loans to/from subsidiaries and
investment income)
Ø Financing activities
(issue of equity/preference capital, loans taken/paid back and dividends)
The cash flow statement
could be called a perfect X-ray of the
financial transactions of a company. In other words, that a company churns huge
profits does not necessarily indicate its good health. And it may also not be
generating enough cash to service its shareholders with dividends.
Operational
cash flows:
Huge profits need not mean good health-they could be blocked in inventories and
receivables, and the company could actually be cash strapped. Sometimes,
companies report higher sales by dumping finished goods to its dealers at the
fag end of the financial year.
Going by the profit and
loss account alone, not many would have resisted investing in the stock. There
are several instances where companies report negative cash flow from operating
activities, by artificially raising inventories and other current assets. Cash
generation from operations would be a much better tool if taken as a proportion
of its net sales-the higher the percentage, the better. In other words, a
company that generates, say, Rs 10 crore of cash on sales of Rs 100 crore is
much better placed than a company that generates Rs 5 crore on similar sales.
Investing
cash flows:
The other important sections consist of cash flow from investing activities and
financing activities. Cash flow from investing activities reflects how the
company has deployed its resources in fixed assets, investments (equity and
debt), loans to/from subsidiary companies as well as receipts in the form of
investment income and sale of fixed assets and investments. Generally, the
figure of cash flow from investing activities is negative; that is, there is
usually a cash outflow mainly on account of creation of assets, as companies
have to make investments to maintain future growth. Besides, like most
individuals, companies tend to set aside some funds for investment purposes,
which form the other sources of income for the company.
Financing
cash flows: On
the other hand, cash flow from financing activities consists of funds raised
through issue of equity/preference capital, loan taken/paid and dividend paid,
among others. The ingredients of this section are basically the outcome of the
first tow sections (cash flow from operating activities and from investing
activities). In other words, if the company is a good generator of cash, it
becomes capable of financing its investing activities. It would also be in a
reasonably good position to retire its debt and pay good dividends. Thus, an
outflow of cash (with respect to financing activities), by way of debt
repayments and dividend payout, would be a healthy sign. Similarly, a company
not capable of generating sufficient cash so as to fund its investment
activities will, in most cases, be seen raising funds (equity as well as debt),
much more than the quantum of outflow in this section.
Net cash
flows: The aggregate of the
three sections (cash flow from operating, investing and financing activities)
is the final output, known as net increase/decrease in cash and cash
equivalents. Companies that manage their cash flows efficiently generally end
up with a positive figure.
FREE CASH
FLOW: In
stock valuation, most analysts prefer using discounted cash flow (DCF)
technique to value stocks, in stead of the traditional tools such as,
price-earnings ratio or price-book value ratio. To calculate DCF, one need to
have details relating to fresh cash flows, that is cash flow from operations
adjusted for investments in fixed assets, working capital and the level of debt
raised by the firm. Such information is however available only once a year, and
often at considerable lag. Without timely and regular access to information on
free cash flows, opinions tend to be based on multiples such as, P/E ratio or
P/BV ratio. These are only proxies. Many experts consider an analysis based on
P/E ratio and P/BV ratio as irrational compared to the one that is based on
discounted cash flow, which is rational.
CHAIRMAN’s SPEECH
|
This is where the “vision
thing” happens. The Chairman’s speech should ideally reflect actions and plans
for the future. The chairman talks about the general direction of the company
and the industry, sometimes the economy. He usually makes this speech at the
company’s annual general meeting, which is often published as an advertisement
in newspapers and magazines. Sometimes, they provide the occasional insight.
For example, Mr A.M.Naik,
Chairman of Larsen and Toubro, talks about implementation of the company’s
strategic plan for five years, starting from April 2006. The Chairman foresees
opportunities in defence, nuclear and aerospace industries. He further says
that they have identified the Middle East and China India
DIRECTORS’ REPORT
|
Usually, this report
contains info about the performance of the company for the year to which the
report pertains to. If the performance is bad, the directors are likely to give
reasons for the same and vice versa. Directors usually declare dividends in
this section of annual report. Segmental reporting is also given here. Capacity
utilization, in case of manufacturing companies, is divulged.
AUDITOR’s REPORT
|
This can be most boring
part of an annual report. In most cases it will merely state that the profit
and loss account and balance sheet give a true and fair view. But it can also
tell us if the management is up to any unacceptable or unethical accounting
practices.
Sometimes, companies do not make provisions for
certain exigencies.
Sometimes, the companies change accounting
policies, which make comparison with prior period performance less meaningful.
MISCELLANEOUS INFORMATION
|
Apart from the above details, companies can also
provide a host of other information that can influence one’s investment
decision. These include number of employees, shareholding pattern, risk
management and market information.
Risk
Management:
Infosys Technologies’ annual report lays out the perceived risks the company is
facing and how the management plans to tackle them. Such openness has helped it
get a superior discounting, even to other high-performance software stocks.
Market
information:
This includes stock exchange information such as book closure date, record date
for dividend, percentage of shares already under demat, price performance of
shares listed outside India (like GDR and ADR).
Annexure to
the directors’ report:
It tells, among other things, us about the salaries the company’s executives
are being paid.
FINANCIAL SUMMARY
|
This includes the company’s long term past
performance.
Fundamental data: Many companies give financial
data for the past 10 years. Things covered under this include equity capital,
net worth, sales, EPS, dividend, book value, etc. But, some companies give info
about for five years only.
Technical data: Some companies even give share
price data for the past one year.
Note: This post was actually written in September 2006, but posted now only.
Disclaimer: The author is an investment analyst, equity investor and freelance writer. The author has a vested interest in the Indian stock markets. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:
Disclaimer: The author is an investment analyst, equity investor and freelance writer. The author has a vested interest in the Indian stock markets. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:
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