Annual report can reveal the secrets a company wants to hide: Here's how to uncover
People who invest on the basis of tips are investing blindly. But even investors who study the fundamentals of companies before buying stocks usually restrict the research to basic details such as revenues, net profit, earnings per share (EPS) and price to earnings ratio (PE ratio). This information is available in the quarterly numbers declared by companies, so most investors don’t feel it necessary to read the bulky annual report that comes once in a year. However, experts say that reading annual reports is necessary because they contain a lot of information that is not available otherwise. “Reading annual reports becomes an advantage because very few people do it,” says Nilesh Shah, Managing Director, Kotak Mahindra Mutual Fund.
Read it in full
The annual report is a bulky document, sometimes running into 180-200 pages. Experts say one should read the full document. “Investors should go through each line of the annual report,” says Daljeet S. Kohli, Director & Head of Research, India Nivesh Securities. To begin with, focus on the first part of the report. “Most companies give financial highlights of the past 10 years. While these numbers may not be of much use to institutional investors, they are useful for retail investors to understand how the company has grown in the past,” says Anand Shah, Deputy CEO & CIO, BNP Paribas Mutual Fund. “Read the notice because it gives lot of information and sets the agenda of the annual general meeting. Investors should also read the chairman’s speech that gives a clear vision about the future and the directors’ report (along with management discussion and analysis) which explains current business structure before going to the net profit fi ..
Companies with large cash flows
Read it in full
The annual report is a bulky document, sometimes running into 180-200 pages. Experts say one should read the full document. “Investors should go through each line of the annual report,” says Daljeet S. Kohli, Director & Head of Research, India Nivesh Securities. To begin with, focus on the first part of the report. “Most companies give financial highlights of the past 10 years. While these numbers may not be of much use to institutional investors, they are useful for retail investors to understand how the company has grown in the past,” says Anand Shah, Deputy CEO & CIO, BNP Paribas Mutual Fund. “Read the notice because it gives lot of information and sets the agenda of the annual general meeting. Investors should also read the chairman’s speech that gives a clear vision about the future and the directors’ report (along with management discussion and analysis) which explains current business structure before going to the net profit fi ..
Companies with large cash flows
A large cash flow from operating activities is a healthy sign and shows that all is well with the company
Deciphering the numbers
Investors also need to understand the difference between what the company says and what it means. “While some companies tell outright lies, others tell truths that are convenient to them. Since no company is going to tell the whole truth, you should be able to read between lines,” says Nilesh Shah. However, the average investor may find it difficult to read an annual report in detail and understand it in its entirety. Here are a few key points that
Continuity is key
Continuity is an important parameter. Compare each figure with that of the previous years to get an idea of how the company has done. “If any figure is significantly higher or lower than that of previous years, investors need to delve deeper. Don’t assume that something is wrong, but certainly check the reasons behind this deviation,” says Kohli. “There should also be continuity and coherence between all parts of annual reports. For example, the numbers
Is the sales real?
Companies declare sales figures in their quarterly results. But are these sales real? Several sales based ratios (market cap to revenues) are used for valuations. The first check is to add up sales of the four quarters to see if they match the annual sales figure. Checking sales growth with that of increase in debt is another way. “If the debt is also rising with the sales, it may mean the company is buying sales (giving away goods without bothering to
Is the profit real?
Just like sales, you also need to cross check the net profit figure because price to earnings (PE) ratio is the most commonly used valuation tool. Companies manipulate the profit figure by providing for excessive (or even less) depreciation. While quarterly numbers give just a consolidated figure, annual reports give a detailed breakup of the depreciation provided for each asset. The depreciation provided should be reasonable. Be alert if there is a sudden increase or decrease in the depreciation figure. “If a company is providing 10 years of depreciation for computers, it is a clear case of inflating the profit,” says Nilesh Shah. Research and development (R&D) expenses is another head that needs close verification. “Ideally, the R&D expenses should be written off in that financial year itself. However, companies usually capitalise it and then write it off over a period of time. It’s a red flag if the write off period is more than four years,” says Mehta of Equirus. Capitalising interest (instead of showing it as expense, it is added to the cost of project) is another strategy used by companies. Some even capitalise the mark to market losses on forex positions on loans taken for buying assets and usually add this loss to the loans. Another trick to inflate profit is by avoiding the profit and loss account altogether and taking expenses directly to the balance sheet.
The Economic Times, New Delhi, 04th September 2017
Deciphering the numbers
Investors also need to understand the difference between what the company says and what it means. “While some companies tell outright lies, others tell truths that are convenient to them. Since no company is going to tell the whole truth, you should be able to read between lines,” says Nilesh Shah. However, the average investor may find it difficult to read an annual report in detail and understand it in its entirety. Here are a few key points that
Continuity is key
Continuity is an important parameter. Compare each figure with that of the previous years to get an idea of how the company has done. “If any figure is significantly higher or lower than that of previous years, investors need to delve deeper. Don’t assume that something is wrong, but certainly check the reasons behind this deviation,” says Kohli. “There should also be continuity and coherence between all parts of annual reports. For example, the numbers
Is the sales real?
Companies declare sales figures in their quarterly results. But are these sales real? Several sales based ratios (market cap to revenues) are used for valuations. The first check is to add up sales of the four quarters to see if they match the annual sales figure. Checking sales growth with that of increase in debt is another way. “If the debt is also rising with the sales, it may mean the company is buying sales (giving away goods without bothering to
Is the profit real?
Just like sales, you also need to cross check the net profit figure because price to earnings (PE) ratio is the most commonly used valuation tool. Companies manipulate the profit figure by providing for excessive (or even less) depreciation. While quarterly numbers give just a consolidated figure, annual reports give a detailed breakup of the depreciation provided for each asset. The depreciation provided should be reasonable. Be alert if there is a sudden increase or decrease in the depreciation figure. “If a company is providing 10 years of depreciation for computers, it is a clear case of inflating the profit,” says Nilesh Shah. Research and development (R&D) expenses is another head that needs close verification. “Ideally, the R&D expenses should be written off in that financial year itself. However, companies usually capitalise it and then write it off over a period of time. It’s a red flag if the write off period is more than four years,” says Mehta of Equirus. Capitalising interest (instead of showing it as expense, it is added to the cost of project) is another strategy used by companies. Some even capitalise the mark to market losses on forex positions on loans taken for buying assets and usually add this loss to the loans. Another trick to inflate profit is by avoiding the profit and loss account altogether and taking expenses directly to the balance sheet.
The Economic Times, New Delhi, 04th September 2017
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