How to Read an Annual Report in 1 Hour

Investors in the stock market are looking for ways to improve their return on investment. They understandably want to make the maximum possible gains with the least amount of risk.

One of the ways to do that is to find fundamentally strong stocks.

These are debt free companies, high ROE stocks, top growth stocks, high profit margin companies, consistent compounding stocks, etc.

Finding such stocks and then buying them at the right price can be very profitable.

So how do you go about it?

Well, the best way is to read annual reports of as many companies as possible.

This one activity will put you ahead of most investors in the market. It's perhaps the best way to boost your investing profits.

So how do you go about reading an annual report to understand a company's fundamentals?

Let's find out...

What is an annual report?

An annual report is a detailed public report published once a year by every listed company for the benefit of its shareholders.

It's mailed to every shareholder and is also found on the websites of the company and the stock exchanges.

The annual report will tell you all you need to know about the company from a financial and operational perspective.

Reading the annual report is especially useful because it contains vital data, as well as commentary by the leadership, about the company's activities in the past year. It may also provide certain forecasts for the coming year.

It also contains useful information about the industry in which the company operates.

What will you find in an annual report?

The purpose of an annual report is to present all relevant information about the company to the public. This is so that investors (and potential investors) can understand the workings of the company.

To ensure this is done effectively, companies are required by law to provide a huge amount of information. This is why many annual reports are over 100 pages long. In the case of large companies they can be a few hundred pages long.

You will find the following detailed information about a company in its annual report:

• An introduction to the report
• The company at a glance
• The board of directors
• The leadership team
• A letter from the Chairman of the board to the shareholders
• Major achievements during the year
• Operations of the company during the year
• The company's business model
• New initiatives taken during the year
• The outlook for its industry
• Forecasts about the year ahead
• Shareholder information
• Many compliance, governance, and statutory reports
• Auditor's report
• Financial reports
• Annexure and footnotes to the financial reports

How should you read the annual report?

The annual report can seem intimidating at first. But reading it is quite straight forward.

You can choose to read it cover to cover but that isn't the best way to do it. A lot of content in the report is commentary about specific achievements and tasks completed during the year. This may or may not be important.

Before you start reading an annual report, here's a pro tip. Do not waste time looking at all the fancy charts and pictures. You can do this later if you choose to study the company in depth.

The good way to start is from the chairman's letter. As the head of the board of directors, it's his responsibility to take care of shareholders.

The letter will give a bird's eye of the company's performance in the year gone by as well as the outlook for the year ahead.

If there are messages from the CEO/CFO read those as well. Just keep in mind the leadership has a vested interest in presenting the company in a good light. So make it a point to look for any challenges highlighted by the leadership and how they are dealing with it.

Next read the industry section. This is important because no company operates in a vacuum.

A company's relative position in an industry often decides its fate in the long term. Industry leaders tend to dominate smaller and weaker firms. Thus the market rewards these stocks with higher valuations.

Briefly check the shareholders section for any changes in shareholding pattern. Have the promoters/leadership bought or sold shares? If yes, then how much? Have they provided any reasons of the same?

Also check if fresh shares were allotted or bought back and in what amount. Finally, check if any shares were pledged/revoked during the year along with the purpose of the same.

All this shouldn't take you more than 15 minutes. Most of your time should be spent on the financial section.

Here, you will ideally need more than an hour to interpret the numbers in the financial statements as well as the details about them in the annexures.

But it's possible to get a very good idea about the company's fundaments by spending about half an hour or so on the financial statements.

The financial statements are of three kinds. The balance sheet provides details of the assets and liabilities on the last day of the financial year.

The income statement provides details of all the sources of revenue and all the costs incurred during the year.

The cash flow statement provides details of all the cash flowing into and out of the company during the year.

You need to spend just about 10-15 minutes on each to get a good idea of a company's fundamentals.

Calculate the following ratios by plugging in the numbers in the formulae. You can keep the formulae ready in an excel sheet and just plug in the numbers.

Balance Sheet Ratios

• Working capital = current assts - current liabilities
• Book value = total assets - total liabilities
• Inventory turnover = cost of goods sold/ average inventory
• Receivable turnover = sales/ average receivables
• Payables turnover = company's purchases from creditors/ outstanding creditors
• Asset turnover = sales/ total assets
• Fixed assets turnover = sales/ fixed assets
• Working capital turnover = sales/ working capital
• Current ratio = current assets/ current liabilities
• Quick ratio = (current assts - cash)/ current liabilities
• Debt to equity ratio = total debt / shareholder's equity (separate ratios for short term and long term debt)
• Leverage ratio = total assets/ total debt
• Return on assets = net profit/ total assets
• Return on equity = net profit/ shareholder's equity

Income Statement Ratios

• Gross margin = (sales - cost of goods sold)/ sales
• Operating income or EBIT = sales - all costs incurred during operations
• Operating margin = operating income/ sales
• Net margin = net profit/ sales
• Interest coverage ratio = EBIT/ interest expense
• Earnings per share = net profit/ shares outstanding
• Dividend payout ratio = dividend/ net profit

Cash Flow Statement Ratios

• Operating cash flow ratio = operating cash flow/ current liabilities
• Operating cash flow margin = operating cash flow/ sales
• Operating cash flow to net profit = operating cash flow/ net profit
• Short term liability coverage ratio = operating cash flow/ (short term debt + short term part of long term debt)
• Free cash flow = net profit + depreciation - capital expenditure - change in working capital -dividend and/or buyback

In conclusion

Quickly reading about the company's performance in the year gone by and looking at the numbers you have calculated, will tell you a lot about the company in just one hour.

Often you will be able to arrive at a decision to ignore the company even before an hour. This is a good thing because you can the move on to another company.

Never waste your time studying a company with bad fundamentals. It's not worth it.

If, after an hour, you find that a company is fundamentally strong, we suggest taking the time to dig deeper into the annual report. You might just have found your next multibagger stock.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...