Annual reports reveal a company’s innermost secrets

A firm’s annual report and accounts is the most valuable piece of public information investors can get their hands on. So it’s a shame most people ignore them. They see them as either too dry to sift through, or just a long-winded advertisement for the firm.

Many professional analysts and fund managers don’t bother reading annual reports either. This gives the diligent student the chance to gain an edge.

When I was a professional investment analyst, and I wanted to learn about what made a company tick, I would get hold of the last ten years’ annual reports. 

I’d study the firm’s financial performance and read what the management had said. Understanding what had happened in the past gave me a better idea of what might happen in the future.

Nowadays there are bits of software that you can use that can take a lot of the legwork out of the number crunching. But that doesn’t mean that scrutinising the annual report is no longer worth the effort. That’s because there’s a lot more to annual reports than just numbers.

Buried deep in the dry matter are disclosures that can tell you a great deal about how a company is run and whether it has the potential to be a good investment. You just need to know where to look.

Check the directors’ report

Begin with the directors’ report, which will give you an insight into how much incentive the company’s top management has. First, you can see how much the managers are being paid. This should be a reasonable amount, to retain the services of genuinely good people.

What you don’t want to see is a gravy train that enriches the management regardless of how the company has performed.

Also look at how many shares the key management team own – the chief executive and the finance director and those who run the company’s businesses. A good rule of thumb is that the value of shares owned by the top managers should be at least twice their basic salary.

Any less than this and there could be grounds to question whether their interests are really aligned with those of shareholders – do they have enough skin in the game? It is quite amazing how few shares managers sometimes own.

This leads on to details of long-term incentive plans (LTIPs) and annual bonuses. In most cases, this means that management are awarded large cash bonuses, free shares, or the option to buy shares at a knockdown price if certain targets are met.

This might be acceptable if the targets are challenging enough. But it pays to be wary of plans that are based on growth in earnings per share (EPS). EPS can be increased by buying companies or overinvesting in existing businesses. It can also be boosted by buying back shares, so check if the company is doing this.

Unfortunately, higher EPS doesn’t always mean that shareholders get richer. It is better to have a management team that has an incentive to boost return on capital employed (the money invested in the company) instead.

You should also check how many outstanding options there are to buy shares in the future. This can sometimes add up to a large proportion of the existing shares in issue. If all these extra options are exercised, the increase in shares can dilute existing shareholders, and lead to lower EPS and a lower share price in future.

Be wary of hidden debt

Some companies rent buildings or equipment rather than own them. They often sign up to long-term agreements to pay rent. These obligations aren’t on the balance sheet, but the minimum future payments can be found in the notes to the accounts. Many people see these as a form of hidden debt and the numbers involved can be frighteningly large.

Pension funds also have the potential to cause trouble. Shortfalls (or deficits) are disclosed on balance sheets. But in the accounts you can find more details of how troublesome they could become.

Pay particular attention to where the fund has invested its money (does it have too much in shares or bonds?) and the assumptions made on things such as future inflation, how long employees will live after they retire, and future investment returns.

Compare the firm’s assumptions with those made in previous years and ask yourself whether they are prudent or too generous.

Also make sure you read the company’s accounting policies, which are often ignored until it is too late. It can be worthwhile looking at policies on when sales and profits are recognised, or the depreciation rate of fixed assets.

Compare these with previous years to see if they’ve changed. Also compare these policies with those adopted by competitors to see if they are more conservative or aggressive than is usual in the industry.

Digging a little deeper

Annual reports can also point you to other sources of information. One big frustration is that company management can sometimes be vague when talking about a particular business you might be interested in. But the annual report will usually give you the names of firms that form part of the bigger group.

An important division of the company will often be its own separate company (such as ABC Limited), which files its own accounts with Companies House.

You can often download these filings for just £1 over the internet at Companieshouse.gov.uk. These filings can contain some very useful information that can greatly enhance your understanding of the parent company.