Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

Ivesting Tips : Why read an annual report?

2 min read

Now that you've acquired the MBS degree (Master of the Balance sheet), you need to turn your attention to post-MBS studies. A company's annual report has reams of matter apart from the actual balance sheet and Profit & Loss figures, much of which could aid you in forming an opinion about the company.

The Auditor's Report & the Notes to the Accounts
Let's start with the Auditor's Report and the "Notes to the Accounts." The Auditor's Report will tell you what the auditor thinks about how the accounts have been drawn up. If he thinks that some accounting treatment is a bit dicey, and would affect the profits, he makes what is called a qualification to the accounts. In plain words, what he's doing is drawing your attention to the fact that the profit would have been different if the accounts had not been massaged. Usually, the auditor also tells you what impact the faulty accounting policy has on the firm's profits.

The Notes to the Accounts contain some fine print that is well worth studying. For instance, the notes to Reliance Industries' accounts point out that inter-divisional sales of Rs3929cr are included in the company's sales figure. Inter-divisional transfers are sales between one division of the company to another. This amount, therefore, should not be included in the total sales figure. Or take another example. The Notes point out that RIL has changed its method of depreciation, with the result that the profit for the year has been understated. So if you didn't look at the Notes, you could be misled.

Also included is quantitative information such as installed capacity, its utilisation, volumes sold etc. This will enable you to find out whether an increase in sales, for example, is due merely to higher prices, or to increase in volume of goods sold. Since the quantities of products produced are given, you will be able to get information about the trends in volumes of the different products.

Spare a glance at the figures for imports and the foreign exchange earned. That'll enable you to gauge the impact, for instance, of a depreciation in the currency.

The Cash Flow Statement
The cash flow statement reconciles the opening balance of cash (and money in the bank) with the closing balance. It shows the effect on cash of the various transactions. Since profit is often dependent upon the accounting policies you adopt, the cash flow statement is a more transparent way of showing a company's operations than the P&L account. It provides additional data. For instance, while the change in the debt outstanding can be gleaned from the balance sheet, the cash flow statement will tell you how much of borrowings have been repaid and how much fresh borrowing has been resorted to.

The cash generated from operations is an important indicator. If that figure is negative, it means that cash is being sourced from external sources to fund existing operations. That's certainly not sustainable in the long run.

 

Chairman's Communication and Director's Report
This is sometimes a mere PR exercise, but it could also be a source of insight into a company's strategy. An example would be Subhash Chandra's vision for Zee, which clearly charts out the way he wants the group to grow. The Directors' Report and, in some cases, the Management Discussion and Analysis, sets out the management's view of the operations of the company during the year. In a multi-divisional company, the performance of the various divisions are analysed in some detail. This would enable you to know which businesses are doing well and which not so well.

Reconciliation with US GAAP
Thee days, with an eye on the ADR market, many companies have started reconciling their accounts with the accounts according to the US generally accepted accounting principles (GAAP). For Reliance Industries, you will notice that the profit under US GAAP is much lower than the profit under Indian accounting norms. That's because of deferred tax. There is sometimes a difference between the year in which a transaction affects taxable income and the year in which it enters into pre-tax income. For instance, higher depreciation is permitted under tax laws as compared to the Companies Act. Over time, however, such differences are ironed out. The benefits of higher depreciation, for instance, are lost over a period of time. So unless accounting is made for deferred taxes, there could be sudden shock in the year when the tax shelter is withdrawn. Accounting for deferred tax smoothens out such fluctuations.
 

 

Rajandran R Founder of Marketcalls and Co-Founder Algomojo. Full-Time Derivative Trader. Expert in Designing Trading Systems (Amibroker, Ninjatrader, Metatrader, Python, Pinescript). Trading the markets since 2006. Mentoring Traders on Trading System Designing, Market Profile, Orderflow and Trade Automation.

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