Reading The Fine Print

Rahul Oberoi/Money Today        Print Edition: February 2013

"In terms of marketable securities or new offerings, we've never bought anything that's been pitched to us by an investment banker or broker. We read hundreds and hundreds of annual reports every year." - Legendary investor Warren Buffett.

A company's annual report is an ocean of information for investors . From financial figures to salaries of directors and chief executive officers, it has all the information an investor is likely to need. It also gives an account of how the company has performed in the preceding year and throws light on its future plans.

While the most searched figures in annual reports are sales, net profit, operating profit and the different financial ratios, there are a lot of other important points that are ignored by all but the most seasoned investors and which can tell a lot about a company.

Director's Report
The director's report talks about developments that have happened after the balance-sheet date. Other than the financials, it talks about expansion plans, employee productivity and near-term growth plans. It also mentions the products and services introduced during the year and their potential, besides abnormal expenditures or negatives that have hit margins. Then there is an assessment of the current year's prospects, which is important for fundamental analysis.

Harsha Upadhyaya, head of equities, Kotak Mutual Fund, says, "The statement gives the big picture. It is about the progress in the preceding year and prospects. Even the goals may be mentioned. Overall, it enables investors to understand the strategic direction of the company."

Report on Corporate Governance
It includes disclosures about board of directors, appointment of nonexecutive directors, constraints imposed on management power and ownership concentration, financial information and executive compensation. The level of transparency, fairness and accountability in dealings with the constituents of the business shows how stable and strong the company is.

"In fundamental analysis, investors need to keep a close eye on the way companies keep managements in check and ensure full financial disclosure and board independence and see to it that shareholder rights are protected. Good governance can increase a company's valuation and positively impact its bottom line," says Sunil Goyal, managing director, Ladderup Corporate Advisory.

Events After the Balance-sheet Date

The annual report is usually prepared three-four months after the balance-sheet date and may miss important developments which may have happened in the intervening period. These developments may have at times substantial implications for the company's financials and growth prospect.

Annual reports also contain detailed information about events after the balance-sheet date. One example is a fire accident on the shop floor which may affect production for a while and its likely impact on profits. This must be read carefully if one wants to remain up-to-date about the company.

Remuneration to Directors

Annual reports tell how much the top executives are paid. Experts say there must be continuous monitoring of compensation that the CEOs receive and their performance. "The rewards and salaries should not be just for their designations but performance. Hence, it's important to study the salaries of directors and CEOs," says DK Aggarwal, chairman and managing director, SMC Investments and Advisors.

"Information about management salaries is important and should be examined in the context of the company's overall performance. Market practices, along with industry-specific nuances, need to be understood for properly interpreting this information," says Rakesh Mehta, assistant research manager, Fullerton Securities & Wealth Advisors.

Management Discussion

The Management Discussion and Analysis (MD&A), usually put at the start of the annual report, is supposed to be a frank commentary on the management's outlook about the company.

"It is a very important section of the report, especially for those analysing the company's fundamentals. The MD&A report is a powerful medium for communicating to shareholders a meaningful assessment of the company's performance, liquidity and prospects," says Aggarwal of SMC Investments and Advisors.

Notes to Accounts
These non-financial notes relate to details about financial numbers and are extremely important for appropriate interpretation of the company's financials.

"The purpose of the notes to accounts is to clarify and qualify the information provided in the accounts. Hence, reading these carefully along with the financial numbers is of utmost importance," says Sudip Bandyopadhyay, managing director and CEO, Destimoney Securities.

Contingent Liabilities
Contingent liabilities are possible future liabilities. Due to lack of certainty, they are mentioned below the balance sheet. However, in certain cases, they can have serious implications. For instance, during the credit crisis of 2008 in the US, several contingent liability instruments such as Collateralised Debt Obligations and Credit Default Swaps became real liabilities, leading to bankruptcy of such big companies as Lehman Brothers and Bear Stearns. Hence, it's important to do a detailed analysis of all contingent liabilities.

Bandyopadhyay of Destimoney Securities says, "Contingent liabilities may have a significant impact on the company. It's important to understand their nature to assess the possible impact they can have on the company."

"Contingent liabilities give a sense of the risk and concerns associated with key assumptions made during the analysis," says Mehta of Fullerton Securities & Wealth Advisors.

Auditor's Report
The auditor's report is an essential tool for reporting financial information. Since many third-party users prefer certification of financial information given in annual reports by independent auditors to ensure it is authentic, many auditees rely on auditor reports to certify their information to attract investors, apply for loans and improve image.

The auditors, when they are in disagreement with the management, qualify the report. It's an independent source for verifying the correctness of statements and facts mentioned in annual reports. The auditors also add notes to balance sheets which highlight lapses in compliance with rules or other abnormalities, deferred revenue expenses, wrong classification of expenses and treatment of deferred revenue expenditure.

These are important pieces of information for investors. "Reading between the lines helps investors make a judgment about the financial facts given in the report," says K Jayaraman, research associate, Bonanza Portfolio.

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