Annual Report Analysis

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BI > JUNE 2006
What's Important in an Annual Report
Running a Faster Paper Chase
by Bob Adams
Editor's note: This article is based on a class taught by Bob Adams at past CompuFest meetings and is just a sample of the excellent education available at the annual event organized by the Computer Group Advisory Board. This year's meeting will be June 23-25 in Reno, Nev. Bob, a CGAB vice president, will teach sessions titled Advanced SSG Topics: Judgment Aids; Take the Oops Out of the SSG; and Follow Your Stocks: A Monthly Analysis Tool. CompuFest 2006 details and registration information are available at Corporate annual reports are important research tools that enable investors to keep current on the outlook for a company and to follow trends from year to year. Some key trends to watch are sales, profits, inventory, receivables and debt levels. In addition, read the footnotes to ferret out pertinent information. Annual reports have two major sections: the glossy paper at the beginning and the cheap paper everywhere else. The truly revealing information is on the mundane paper in the back and in the flimsy booklet for the annual meeting notice and proxy statement.

Buried a half dozen pages from the back of the proxy statement -- sometimes for good reason -- is a graph comparing the company's stock price history with that of a peer group and of the S&P 500 index. This graph can't be beat for a snapshot of a company's performance.

Stay away from companies with numerous pages of explanatory notes except for industries such as banking that require many notes. Search for key words such as litigation, relationships, acquisitions and joint ventures. If you find any of these topics, scrutinize them closely. (Editor's note: You probably can run a search for key words in PDFs of annual reports you download from the Internet. Check your Adobe software for this function.) The relationships area of the annual report discusses loans made to company officers as well as business deals in which officers in both companies are somehow re-lated. If a search for acquisitions turns up a series of deals, be wary because it's often difficult to grow a company through acquisitions. Improving existing products and creating new, innovative offerings -- in other words, "organic growth" -- are usually better ways to grow a company. Information Not To Gloss Over

Three areas in the glossy section contain information worth investigating. I discussed them and additional points about analyzing annual reports in an article in the July 2002 issue of BetterInvesting. The Letter to Shareholders or Letter From Management

Poor management relies on alibis and excuses when talking about lackluster performance, while good management discusses problems candidly and outlines a plan to reverse negative trends. Management's Discussion and Analysis (MD&A)

MD&A covers operating trends and market factors that affect growth and profitability, key concerns of the Stock Selection Guide (the chief stock analysis tool for the BetterInvesting community). If management indicates a downward trend for the future, review the assumptions in your SSG analysis.

The Auditor's Statement
Look for any qualifications to the CPA firm's opinion on the company's financials and investigate exceptions or references to the footnotes.
Numbers That Really Count
The crucial numerical data is on the cheap paper in the three main financial statements: balance sheet, income statement and statement of cash flow. Later, I'll show you how to quickly analyze the data with a spreadsheet available at my website.

A stock's value comes from a company's long-term ability to create profits from invested capital. Financial statements are a snapshot of how a company creates value.
Income Statement: Indicates how good the company is at making money -- the bottom line. (Ann Cuneaz wrote an article about the income statement in the May issue.)
Cash Flow Statement: Indicates...
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