Thursday 21st April 2005

 

Understanding the annual report

 
 
 
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A total of 19 out of 31 companies listed on the T&T Stock Exchange have a December 31 year end.

As we move towards the end of April most of these companies would have already presented their annual reports to their shareholders. Those that have not yet done so must surely be very close.

All public companies are required by law to provide to every shareholder a copy of their annual report. Yet despite the significant degree of time and cost involved in preparing and disseminating these reports many investors only offer a cursory glance at its contents before casting it aside.

Even so as a shareholder you should note that the annual report is arguably the single most important document that you will receive from a company and should form the basis for your future investment decisions.

The indifference of some shareholders often comes from the inability to properly understand the contents of the report. This article provides an insight into the information contained in the annual report especially as it relates to your future investment decisions.

Why an annual report?

An annual report includes information about a company’s performance during the previous year, as well as management’s view of the company’s strategy for the future.

As a shareholder your objective should be to use this information to hold management accountable for their stewardship of shareholder resources over the past year as well as use management’s strategies to form your own prediction on how the company will perform in the future.

If you are a potential investor then the annual report will help determine whether a company might be an attractive investment. To this end the annual report can contain useful information regarding a company’s corporate mission, business model and quality of leadership. These factors though often overlooked should form part of the investment decision making process.

One of the principal tenants of finance is that a company exists primarily to add value to its shareholders. The annual report provides the basic mechanism of accountability in this relationship and therefore lies at the core of good corporate governance.

Shareholders and potential investors alike who underestimate the importance of financial disclosure within the context of corporate governance should look no further than the spectacular collapse of Enron, Global Crossing and World Com in the United States and the debilitating impact that this had on its stakeholders.

With the benefit of hindsight we now know that the warning signals surrounding the aforementioned collapses were out there for all to see. However, from the investor’s perspective and especially in our local environment there is a real aversion on the part of the average investor to reviewing a company’s financial statements.

This often means that publicly available information is not readily and accurately absorbed into a company’s share price resulting in investment decisions which to the seasoned observer may seem irrational.

Financial statements

The financial statements which form part of the annual report present a summary of the company’s financial situation. Consolidated results are usually presented meaning that the financial results of all of the company’s business segments and subsidiaries have been added together into one report.

These financial statements carry information on total revenues and expenses (the income statement), assets, liabilities and shareholders’ equity (the balance sheet) and the flow of cash in and out of the company (the cash flow Statement).

These along with the statement of changes in shareholders’ equity form the core financial record of a company’s performance in the current year which is presented with a comparison of similar transactions from the prior year.

The ability to compare transactions and activities from one year to the next is the most basic form of financial statement analysis and should be well within the grasp of all shareholders.

Company directors who are keen on proper disclosure and good corporate governance would often provide an explanation for significant year on year changes as depicted in the financial statements.

Earnings is key

The investor community generally places the most emphasis on the income statement.

Key items to look out for in the income statement include the level of revenues directly resulting from core business activities, income from investments and one off sources of income.

The other part of the income statement details expenses with key items being costs associated with generating sales, general operating costs, finance costs and taxes. There may also be one off expense items.

It is important that an investor isolate one off income and expenditure items when conducting their analysis since as the name suggests these items will not recur in the future.

Apart from this obvious point, one off items can also distort performance relative to another company thus making comparisons between companies difficult.

For investors the most important benchmark comes at the end of the income statement. The EPS or earnings per share takes the profits attributable to the shareholders and divides it by the number of shares in issue. This has the effect of attributing part of the company’s earnings to the number of shares you own and also allows you to compare these earnings to your earnings in other companies.

Cash is king

The difference between earnings and cash flow is often misunderstood.

The cash flow statement reflects the total amount of actual cash that has moved in and out of a company.

On the other hand earnings depend on the manner in which transactions are recorded and the timing of those transactions.

Earnings can potentially be manipulated while the cash flow statement is exactly what it purports to be and can’t be easily manipulated to suit management’s specific circumstances.

As a general rule, you should be concerned about an overall negative cash flow position even if a company is recording profits. Alarm bells should really be ringing when there is a negative cash flow from operations as this means that the company is not generating cash from its core business activity.

Summing it up

The balance sheet represents a snapshot of the company at a specific point in time. In general it describes the company’s assets and liabilities.

Shareholders will be particularly interested in a company’s debt burden as the higher the level of debt as a percentage of the company’s equity the higher the risk of your investment.

Last but not least are the notes to the financial statements which simply provide more details on specific line items. Some of these additional disclosures are required by the relevant accounting standards and some also arise from management’s willingness to disclose additional information as part of their corporate governance system. Either way these notes can provide useful insight into a company’s performance.

You are advised to take the time to review the annual report and let it inform your investment decisions.

If there are items that you do not quite understand please be sure to contact your stockbroker. As a shareholder the law empowers you so that you can safeguard your investment, please do so as best as you can.

Ian Narine can be contacted at [email protected] or at http://www.wiseequities.com

 

 

 

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