Do you skip these while reading annual reports? - Views on News from Equitymaster

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Do you skip these while reading annual reports?

Mar 13, 2012

The very prospects of hiring a new employee, getting married or seeking business partners compel us to have thorough knowledge of the individual we are to get associated with. Hence it is not just the curriculum vitae (CV) that we rely on. Background checks, references and high compatibility levels are necessary to help build confidence about our prospective choices. But why do these skip our checklist when it comes to making decisions for our financial well being? More often than not, investment decisions in stocks, even if independent, is solely based on a skimping glance at the annual reports. These annual disclosures are for a company what a CV is for an individual. One, the annual report is supposed to be prima facie reliable, exhaustive and most updated account of the entity's track record. Secondly, it is instrumental in making judgment about its possible future. However, as pointed out, a skimping glance may often prove misleading.

The accounting statements can certainly give you some quick ratios and growth numbers. The income statement, balance sheet and cash flows are therefore often the first contacts with an annual report. The management discussion and analysis comes a close second. For it at least tell us what does the company do. But equipped with the basic knowledge of business and financial performance, very few investors bother to dig deeper. But herein lays the pitfall. While the business model and financials of some companies could give sufficient warning of an impending disaster, that of many others don't. Satyam Computers being a case in point. If only investors had dug deeper into the logic of an IT company having numerous subsidiaries, rather than being content with its cash heavy balance sheet.

So to help you be on your alert, armed with nothing else but annual reports, we will list out some key disclosures in annual reports that should not skip your scrutiny. In this series of articles (Annual Report Screeners) we will not talk about the usual ratios and valuations, but other factors that will help you decide if the stock is compatible with your long term portfolio.

Screen 1: Related party disclosures

Indian Accounting Standard 18 requires companies to disclose transactions that the entity has had with directly or indirectly controlled companies, associates, joint ventures or individuals having ownership, voting power or significant influence on it.

The nature, volume and value of transactions are to be enlisted as per this disclosure. Hence transfer of goods, funds or even provisions made or written off against the said entities will appear under this disclosure. As a matter of corporate governance, companies therefore should cite irrecoverable loans, excess inventories with subsidiaries and associates

Since family controlled businesses represent almost 80% of the listed companies, their disclosures elicit special interest in this regard. These companies carry on their business through subsidiaries, associates and acquire interest in other enterprises. The transactions between these entities therefore offer important information about whether there is scope for siphoning off funds from the parent entity or tax evasion. One more instance where we can find these types of transactions are directors entering into transactions with the company to gain personal benefit. Higher transparency in this regard, could on the other hand, build confidence about the proposed investment target.

We will bring to your notice more such pertinent disclosures in the subsequent articles, that will help you screen companies and look beyond the obvious.

Tanushree Banerjee

Tanushree Banerjee (Research Analyst), is the editor of Stock Select and Forever Stocks. Tanushree started her career at Equitymaster covering the banking and financial sector stocks and scrutinising RBI policies. Over the last decade, she developed Equitymaster's research processes that helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham, and Joel Greenblatt.

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1 Responses to "Do you skip these while reading annual reports?"

Ravi shah

Mar 16, 2016

Ms Tanushree,First of all thanks for your article.I'm life time suscriber of EQM and the reason for taking your service is that I and persons like me cannot read detailed reports of several companies and track news of companies'action, good or bad.We solely rely on you and your team to guide and suggest good quality stocks and at cheap valuations to build long term portfolio.Till now stocks suggested like sail,Idfc,Moil etc giving me 50%negative return but I have faith in your basic policy of investing in quality stocks which will not vanish my capital after holding for 3-4years.

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