How to Read an Annual Report
Reading the annual report thoroughly is a crucial part of value investing.
With a few honourable exceptions, most companies emit annual reports with an upbeat spin - and the only way you will find the truth is to go straight to the accounts.
Even then, the accountants have polished up the statements - it's in the notes to accounts where you'll find all the bodies buried! It's also there that you find some of the more interesting statistics to use in analysis.
For instance, the number of employees and the aggregate salary is always noted.
While that's not always terribly useful, in a labor-intensive sector it can be quite interesting.
It also gives you a good handle on whether the directors have actually achieved the cuts they told you about last year.
An area that is being studied increasingly closely is the note on borrowings.
Right now it's covenants and other limitations that are probably the focus of attention; however if interest rates rise, you'll also be able to check up which companies have fixed debt and which are exposed through floating rate debt.
Cash is a fairly simple concept, you might think.
But be careful; not all cash is available funds.
Here again, trawling through the notes you'll find out whether any of the cash is already spoken for - for instance, client money that is held in segregated accounts.
You also need to pay close attention to the notes when it comes to capitalisation of expenses - this is where you really need to clamber over the fixed assets and the cash flow account to see how the capital expenditure relates to the additions to fixed assets.
Watch out for depreciation policies, too.
It's tempting to flick through the notes on policies, because they are usually boring, and the same as last time.
But depreciation is one of the easiest numbers to fiddle about with; it's also something that can make a big difference to the apparent profitability of asset-intensive businesses such as equipment rentals or datacentres.
Equally, companies occasionally change the depreciation policy and though I'm sure they don't do so just because it will make this year's EPS look better, that comes as a welcome side effect.
Even something as simple as changing from a straight line basis to a reducing balance basis can have quite an impact on profits.
Apart from the accounting treatment used, notes also tell you a number of interesting facts about the way the company has been operating.
Two I've found particularly interesting and, on occasion, profitable are the notes on related company transactions, and on contingent liabilities.
The note on related company transactions is usually quite late on, about note number 18 or 19, and it's usually anodyne.
That's good - this is one of those times that boring is good, and it's boring 99 percent of the time.
But just occasionally it's interesting - and that's usually a bad sign.
Accountants are conservative little creatures, and if they can foresee a loss, and work out how much it will be, they will write it off against the P&L.
But even so, there are some potential losses that won't be written off - but might be included in a note on contingent liabilities.
These are liabilities that probably aren't going to crystallise.
For instance, a company might sell a business and guarantee the level of profits will not undershoot a certain level in the next three years.
It may set that level 50% below what the business was already making, and think there's no way it could perform worse than that - but it should still show a continent liability, just in case.
Now of course in times like these, some of those liabilities that were thought improbable a few years ago are no longer improbable.
They're likely - some of them are happening.
That's where if you read the notes to the accounts you'll be months ahead of investors who only worry about these liabilities when they hit the headlines.
Unfortunately, there is a huge cost to gaining these investment insights.
The notes to the accounts are probably the most boring reading ever devised.
If you suffer from insomnia, this will help.
It's tough being an investor.
But actually, it's even tougher losing money, which is why you really ought to read the notes.
With a few honourable exceptions, most companies emit annual reports with an upbeat spin - and the only way you will find the truth is to go straight to the accounts.
Even then, the accountants have polished up the statements - it's in the notes to accounts where you'll find all the bodies buried! It's also there that you find some of the more interesting statistics to use in analysis.
For instance, the number of employees and the aggregate salary is always noted.
While that's not always terribly useful, in a labor-intensive sector it can be quite interesting.
It also gives you a good handle on whether the directors have actually achieved the cuts they told you about last year.
An area that is being studied increasingly closely is the note on borrowings.
Right now it's covenants and other limitations that are probably the focus of attention; however if interest rates rise, you'll also be able to check up which companies have fixed debt and which are exposed through floating rate debt.
Cash is a fairly simple concept, you might think.
But be careful; not all cash is available funds.
Here again, trawling through the notes you'll find out whether any of the cash is already spoken for - for instance, client money that is held in segregated accounts.
You also need to pay close attention to the notes when it comes to capitalisation of expenses - this is where you really need to clamber over the fixed assets and the cash flow account to see how the capital expenditure relates to the additions to fixed assets.
Watch out for depreciation policies, too.
It's tempting to flick through the notes on policies, because they are usually boring, and the same as last time.
But depreciation is one of the easiest numbers to fiddle about with; it's also something that can make a big difference to the apparent profitability of asset-intensive businesses such as equipment rentals or datacentres.
Equally, companies occasionally change the depreciation policy and though I'm sure they don't do so just because it will make this year's EPS look better, that comes as a welcome side effect.
Even something as simple as changing from a straight line basis to a reducing balance basis can have quite an impact on profits.
Apart from the accounting treatment used, notes also tell you a number of interesting facts about the way the company has been operating.
Two I've found particularly interesting and, on occasion, profitable are the notes on related company transactions, and on contingent liabilities.
The note on related company transactions is usually quite late on, about note number 18 or 19, and it's usually anodyne.
That's good - this is one of those times that boring is good, and it's boring 99 percent of the time.
But just occasionally it's interesting - and that's usually a bad sign.
Accountants are conservative little creatures, and if they can foresee a loss, and work out how much it will be, they will write it off against the P&L.
But even so, there are some potential losses that won't be written off - but might be included in a note on contingent liabilities.
These are liabilities that probably aren't going to crystallise.
For instance, a company might sell a business and guarantee the level of profits will not undershoot a certain level in the next three years.
It may set that level 50% below what the business was already making, and think there's no way it could perform worse than that - but it should still show a continent liability, just in case.
Now of course in times like these, some of those liabilities that were thought improbable a few years ago are no longer improbable.
They're likely - some of them are happening.
That's where if you read the notes to the accounts you'll be months ahead of investors who only worry about these liabilities when they hit the headlines.
Unfortunately, there is a huge cost to gaining these investment insights.
The notes to the accounts are probably the most boring reading ever devised.
If you suffer from insomnia, this will help.
It's tough being an investor.
But actually, it's even tougher losing money, which is why you really ought to read the notes.
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