How to open an annual report

An annual report is long because the law asks it to be complete, not because every page is equally useful. This chapter is a reading order for a first pass of about an hour, and a list of the pages that deserve a second hour.

Start at the back of the story, not the front

The chairperson’s letter is a speech. Read it last, or read it first only to see what the company wants emphasised, then check those claims against the statements. The pages that constrain the speech are the consolidated financial statements, the notes, the auditor’s report, and the related-party disclosures. Consolidated numbers include the subsidiaries the company controls. Standalone numbers are the parent alone. For a group that runs its business through subsidiaries, the standalone sheet can look almost empty of the real activity. Know which one you are holding.

An hour, in order

1. Auditor’s report. Look for a qualification, an emphasis of matter, or a key audit matter that names revenue, inventory, or a receivable. A clean opinion is ordinary. A paragraph that argues with management is not.
2. Five-year financial summary, if the company prints one. You want the direction of revenue, profit, debt, and share count before you drown in this year’s notes.
3. Consolidated profit and loss, then the consolidated balance sheet, then the consolidated cash flow. Write the three questions from the earlier chapter in the margin.
4. The note on revenue recognition, the note on borrowings, and the note on contingent liabilities. These three explain more surprises than the rest of the note block combined.
5. Related-party transactions. Who got paid, for what, and whether the amount is large next to profit.
6. Segment information, if the company has more than one business. A single margin can hide a good segment funding a bad one.

Words that should make you turn back a page

‘The company is confident of recovering the amount’ attached to a large, ageing receivable is a hope, not a receipt. ‘Subject to’ in an older style of audit report is a disagreement. A sharp rise in ‘loans to related parties’ needs a commercial reason you can restate in one sentence. A change in accounting policy that lifts profit in the year it is adopted needs the previous year’s profit restated in your own note, so you are not applauding a new ruler.

Also watch the gap between the cash-flow statement and the glossy highlights at the front. Highlights love revenue growth and a new factory. The cash-flow statement will tell you whether the factory was paid for with operations or with a loan that now has to be serviced. Both can be sensible. Only one of them is what the highlight implied.

What you still will not know

The annual report will not tell you the price you should pay, the high of next year, or whether a competitor is about to cut prices. It tells you what this company claims happened, checked to the extent an audit checks it, under stated policies. Pair it with the latest quarterly results if the year-end is many months behind you, and with the shareholding pattern: a rising pledge of promoter shares is a fact about the people in control, and it sits outside the profit statement entirely.

Keep a one-page sheet of your own. Revenue, operating margin, profit, operating cash, debt, equity, share count, receivables days if you computed them, and one sentence on what would make you wrong. Next year’s report then has something to be compared with. A report read in isolation becomes a story. A report read against your sheet becomes evidence.

What to remember

• Read the auditor, the three statements, debt, contingencies, and related parties before the chairperson’s adjectives.
• Use consolidated numbers when the business lives in subsidiaries.
• A policy change that creates profit deserves a restatement in your notes.
• Pledge, shareholding, and the quarters since the year-end sit outside the bound report and still matter.
• Write one page of your own numbers so the next report has a memory to argue with.