How to read an annual report?
This is a quick tutorial that covers my personal approach of reading annual reports, which
is part of what I do for a living as a Finance Storyteller.
By no means do I claim that a short tutorial offers a comprehensive overview, but I do
hope I can help you get started on your journey!
I would love to hear about your experiences of reading an annual report
in the comments below.
First question to ask yourself: WHY?
Why do you read an annual report?
Are you a current or prospective investor that wants to evaluate whether a company is
a good investment opportunity?
Are you an employee or applicant that wants to know how the company is doing
and where it is heading?
Are you a student that needs to analyze an annual report to write a paper?
Before you start reading an annual report, define your guiding question!
If you have a clear guiding question, your brain will focus on sorting through the information
and look for the answers.
Decide which version of the annual report you want to use!
The online interactive version that has videos and easy navigation?
The full-color download version of the annual report?
The official filing to the Securities and Exchange Commission on form 10-K?
Or the hardcopy printed version where you can underline the sections that you find important,
add your question-marks and exclamation marks,
and write down your calculations next to the text.
Find a version that works for you and get started!
Set yourself a time limit.
I recommend setting yourself a time limit of one hour for your initial research.
Annual reports have a typical length of 100 to 150 pages, though I have seen some as short
as 70 pages and some as long as 300 pages.
It is unlikely that you will want to read an annual report from front to cover.
With a time limit of one hour (no more, no less), you do some justice to the depth and
complexity of an annual report, and at the same time the time limit hopefully helps you
to avoid going down a rabbit hole (in other words: getting stuck in trivia)
without seeing the big picture.
Spend sufficient time on both the narrative and the numbers!
I usually split my time 50/50 between them.
On the narrative side, I start with reading the "letter to the shareholders" which usually
gives a good amount of information about what the CEO wants you to know about the company's
vision, strategy, and execution.
Then I turn to the section on business risks, to familiarize myself with the risks that
might adversely impact the company.
Both of these narrative sections tend to be up front in the table of contents
of an annual report.
On the numbers side, I start with the 1-page financial summary which often contains graphs
and tables on what the company considers to be the key performance indicators, and then
I turn to the income statement, cash flow statement and balance sheet to perform my
own independent evaluation of the financial results.
On the income statement, which gives you an overview how much profit a company made during
the year, start with a vertical scan.
Go up and down the income statement and look at the key numbers of revenue, operating income
and net income.
What are these numbers in absolute terms?
How do they look on a relative basis: operating income as a percentage of revenue, and net
income as a percentage of revenue?
What are the biggest categories of cost in the income statement?
Next up: a horizontal scan, what does this year look like compared to previous years?
Is there growth or decline, and by what percentage.
I will link to a related video where I show you a step by step example
of how to analyze an income statement.
On the cash flow statement, start with the main equation on the highest level: what was
the starting cash balance and ending cash balance of the year, and which cash inflows
and cash outflows caused the cash balance to go up or down.
Just like with the income statement, you can then do a vertical scan to look at the biggest
line items, and a horizontal scan to look at the year-over-year changes.
On the Finance Storyteller Youtube channel, I have several case studies available for
you on how to analyze a cash flow statement.
On the balance sheet, look at what a company owns (assets)
and what a company owes (liabilities and equity).
Where are the company's assets concentrated: financial assets such as cash, accounts receivable
and marketable securities?
Fixed assets (property, plant and equipment)?
Or intangible assets like goodwill?
How is a company financed: do they have a lot of debt, or is the right-hand side of
the balance sheet primarily made up of equity?
If the alarm goes off after an hour, summarize what you have learned about the company so
far by answering your guiding question, and listing the datapoints
that you base that answer on.
If you decide that you want to allocate more time for your review of the annual report,
then define how you are going to "peel the onion".
How are you going to dig in deeper, layer after layer, to uncover what you are looking
for in the annual report?
Which line items in the income statement, cash flow statement or balance sheet do you
want to investigate?
Which terminology do you need to understand before you can make sense of the next level
of complexity?
Many of the terms used in income statements, balance sheets, and cash flow statements,
are described in detail on the Finance Storyteller YouTube channel.
In the management discussion and analysis section of the annual report, or the notes
to the financial statements, companies provide detailed explanations of what makes up certain
line items, and how they have developed over the years.
Bonus tip!
Calibrate what you are looking at.
An annual report covers twelve months, but which twelve months?
Many companies report by calendar year, from January through December.
There are a lot of exceptions, where companies define their fiscal year differently.
For example, Microsoft's fiscal year runs from July through June.
Apple's fiscal year runs from October through September.
Walmart's fiscal year runs from February through January.
Make sure you check the dates, to know what you are looking at!
That wraps up the overview of how to read an annual report.
It's time for you to get started by diving into the annual report of your choice.
Let me know what you find!
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