Module 3 Fundamental Analysis

Chapter 3

How to Read the Annual Report of a Company

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M3-Ch3-title

3.1 – What is an Annual Report?

The annual report (AR) is a yearly publication by the company and is sent to the shareholders and other interested parties. The annual report is published by the end of the Financial Year, and all the data made available in the annual report is dated to 31st March. The AR is usually available on the company’s website (in the investors section) as a PDF document or one can contact the company to get a hard copy of the same.

Since the annual report is published by the company, whatever is mentioned in the AR is assumed to be official. Hence, any misrepresentation of facts in the annual report can be held against the company. To give you a perspective, AR contains the auditor’s certificates (signed, dated, and sealed) certifying the sanctity of the financial data included in the annual report.

Potential investors and the present shareholders are the primary audience for the annual report.  Annual reports should provide the most pertinent information to an investor and should also communicate the company’s primary message. For an investor, the annual report must be the default option to seek information about a company. Of course there are many media websites claiming to give the financial information about the company; however the investors should avoid seeking information from such sources. Remember the information is more reliable if we get it get it directly from the annual report.

Why would the media website misrepresent the company information you may ask? Well, they may not do it deliberately but they may be forced to do it due to other factors. For example the company may like to include ‘depreciation’ in the expense side of P&L, but the media website may like to include it under a separate header. While this would not impact the overall numbers, it does interrupt the overall sequencing of data.

3.2 – What to look for in an Annual Report?

The annual report has many sections that contain useful information about the company. One has to be careful while going through the annual report as there is a very thin line between the facts presented by the company and the marketing content that the company wants you to read.

Let us briefly go through the various sections of an annual report and understand what the company is trying to communicate in the AR. For the sake of illustration, I have taken the Annual Report of Amara Raja Batteries Limited, belonging to Financial Year 2013-2014. As you may know Amara Raja Batteries Limited manufactures automobile and industrial batteries. You can download ARBL’s FY2014 AR from here (http://www.amararaja.co.in/annual_reports.asp)

Please remember, the objective of this chapter is to give you a brief orientation on how to read an annual report. Running through each and every page of an AR is not practical; however, I would like to share some insights into how I would personally read through an AR, and also help you understand what kind of information is required and what information we can ignore.

For a better understanding, I would urge you to download the Annual Report of ARBL and go through it simultaneously as we progress through this chapter.

ARBL’s annual report contains the following 9 sections:

  • Financial Highlights
  • The Management Statement
  • Management Discussion & Analysis
  • 10 year Financial highlights
  • Corporate Information
  • Director’s Report
  • Report on Corporate governance
  • Financial Section, and
  • Notice

Note, no two annual reports are the same; they are all made to suite the company’s requirement keeping in perspective the industry they operate in. However, some of the sections in the annual report are common across annual reports.

The first section in ARBL’s AR is the Financial Highlights. Financial Highlights contains the bird’s eye view on how the financials of the company looks for the year gone by. . The information in this section can be in the form of a table or a graphical display of data. This section of the annual report generally does a multi-year comparison of the operating and business metrics.

Here is the snapshot of the same:

Print

The details that you see in the Financial Highlights section are basically an extract from the company’s financial statement. Along with the extracts, the company can also include a few financial ratios, which are calculated by the company itself. I briefly look through this section to get an overall idea, but I do not like to spend too much time on it. The reason for looking at this section briefly is that, I would anyway calculate these and many other ratios myself and while I do so, I would gain greater clarity on the company and its numbers. Needless to say, over the next few chapters we will understand how to read and understand the financial statements of the company and also how to calculate the financial ratios.

The next two sections i.e the ‘Management Statement’ and ‘Management Discussion & Analysis’ are quite important. I spend time going through these sections. Both these sections gives you a sense on what the management of the company has to say about their business and the industry in general. As an investor or as a potential investor in the company, every word mentioned in these sections is important. In fact some of the details related to the ‘Qualitative aspects’ (as discussed in chapter 2), can be found in these two sections of the AR.

In the ‘Management Statement’ (sometimes called the Chairman’s Message), the investor gets a perspective of how the man sitting right on top is thinking about his business. The content here is usually broad based and gives a sense on how the business is positioned. When I read through this section, I look at how realistic the management is. I am very keen to see if the company’s management has its feet on the ground. I also observe if they are transparent on discussing details on what went right and what went wrong for the business.

One example that I explicitly remember was reading through the chairman’s message of a well established tea manufacturing company. In his message, the chairman was talking about a revenue growth of nearly 10%, however the historical revenue numbers suggested that the company’s revenue was growing at a rate of 4-5%. Clearly in this context, the growth rate of 10% seemed like a celestial move. This also indicated to me that the man on top may not really be in sync with ground reality and hence I decided not to invest in the company. Retrospectively when I look back at my decision not to invest, it was probably the right decision.

Here is the snapshot of Amara Raja Batteries Limited; I have highlighted a small part that I think is interesting. I would encourage you to read through the entire message in the Annual Report.

M3-Ch3-chart2

Moving ahead, the next section is the ‘Management Discussion & Analysis’ or ‘MD&A’. This according to me is perhaps one of the most important sections in the whole of AR. The most standard way for any company to start this section is by talking about the macro trends in the economy. They discuss the overall economic activity of the country and the business sentiment across the corporate world. If the company has high exposure to exports, they even talk about global economic and business sentiment.

ARBL has both exports and domestic business interest; hence they discuss both these angles in their AR. See the snapshot below:

M3-Ch3-chart3

ARBL’s view on the Indian economy:

M3-Ch3-chart4

Following this the companies usually talk about the trends in the industry and what they expect for the year ahead. This is an important section as we can understand what the company perceives as threats and opportunities in the industry. Most importantly I read through this, and also compare it with its peers to understand if the company has any advantage over its peers.

For example, if Amara Raja Batteries limited is a company of interest to me, I would read through this part of the AR and also would read through what Exide Batteries Limited has to say in their AR.

Remember until this point the discussion in the Management Discussion & Analysis is broad based and generic (global economy, domestic economy, and industry trends). However going forward, the company would discuss various aspects related to its business. It talks about how the business had performed across various divisions, how did it fare in comparison to the previous year etc. The company in fact gives out specific numbers in this section.

Here is a snapshot of the same:

M3-Ch3-chart5

Some companies even discuss their guidelines and strategies for the year ahead across the various verticals they operate in. Do have a look at the snapshot below:

M3-Ch3-chart6

After discussing these in ‘Management Discussion & Analysis’ the annual report includes a series of other reports such as – Human Resources report, R&D report, Technology report etc. Each of these reports are important in the context of the industry the company operates in. For example, if I am reading through a manufacturing company annual report,  I would be particularly interested in the human resources report to understand if the company has any labor issues. If there are serious signs of labor issues then it could potentially lead to the factory being shut down, which is not good for the company’s shareholders.

3.3 – The Financial Statements

Finally, the last section of the AR contains the financial statements of the company. As you would agree, the financial statements are perhaps one of the most important aspects of an Annual Report. There are three financial statements that the company will present namely:

  1. The Profit and Loss statement
  2. The Balance Sheet and
  3. The Cash flow statement

We will understand each of these statements in detail over the next few chapters. However at this stage it is important to understand that the financial statements come in two forms.

  1. Standalone financial statement or simply standalone numbers and
  2. Consolidated financial statement or simply consolidated numbers

To understand the difference between standalone and consolidated numbers, we need to understand the structure of a company.

Typically, a well established company has many subsidiaries. These companies also act as a holding company for several other well established companies. To help you understand this better, I have taken the example of CRISIL Limited’s shareholding structure. You can find the same in CRISIL’s annual report. As you may know, CRISIL is an Indian company with a major focus on corporate credit rating services.

M3-Ch3-chart7

As you can see in the above share holding structure:

  1. Standard & Poor’s (S&P), a US based rating agency holds a 51% stake in CRISIL. Hence S&P is the ‘Holding company’ or the ‘Promoter’ of CRISIL
  2. The balance 49% of shares of CRISIL is held by Public and other Financial institutions
  3. However, S&P itself is 100% subsidiary of another company called ‘The McGraw-Hill Companies’
    1. This means McGraw Hill fully owns S&P, and S&P owns 51% of CRISIL
  4. Further, CRISIL itself fully owns (100% shareholding) another company called ‘Irevna’.

Keeping the above in perspective, think about this hypothetical situation. Assume, for the financial year 2014, CRISIL makes a loss of Rs.1000 Crs and Irevna, its 100% subsidiary makes a profit of Rs.700 Crs. What do you would be the overall profitability of CRISIL?

Well, this is quite simple – CRISIL on its own made a loss of Rs.1000 Crs, but its subsidiary Irevna made a profit of Rs.700 Crs, hence the overall P&L of CRISIL is (Rs.1000 Crs) + Rs.700 Crs = (Rs.300 Crs).

Thanks to its subsidiary, CRISIL’s loss is reduced to Rs.300 Crs as opposed to a massive loss of Rs.1000 Crs. Another way to look at it is, CRISIL on a standalone basis made a loss of Rs.1000 Crs, but on a consolidated basis made a loss of Rs.300 Crs.

Hence, Standalone Financial statements represent the standalone numbers/ financials of the company itself and do not include the financials of its subsidiaries. However the consolidated numbers includes the companies (i.e.standalone financials)  and its subsidiaries financial statements.

I personally prefer to look through the consolidated financial statements as it gives a better representation of the company’s financial position.

3.4 – Schedules of Financial Statements

When the company reports its financial statements, they usually report the full statement in the beginning and then follow it up with a detailed explanation.

Have a look at the snapshot of one of ARBL’s financial statement (balance sheet):

M3-Ch3-chart8

Each particular in the financial statement is referred to as the line item. For example the first line item in the Balance Sheet (under Equity and Liability) is the share capital (as pointed out by the green arrow). If you notice, there is a note number associated with share capital. These are called the ‘Schedules’ related to the financial statement. Looking into the above statement, ARBL states that the share capital stands at Rs.17.081 Crs (or Rs.170.81 Million). As an investor I obviously would be interested to know how ARBL arrived at Rs.17.081 Crs as their share capital. To figure this out, one needs to look into the associated schedule (note number 2). Please look at the snapshot below:

M3-Ch3-chart9

Of course, considering you may be new to financial statements, jargon’s like share capital make not make much sense. However the financial statements are extremely simple to understand, and over the next few chapters you will understand how to read the financial statements and make sense of it. But for now do remember that the main financial statement gives you the summary and the associated schedules give the details pertaining to each line item.


Key takeaways from this chapter

  1. The Annual Report (AR) of a company is an official communication from the company to its investors and other stakeholders
  2. The AR is the best source to get information about the company; hence AR should be the default choice for the investor to source company related information
  3. The AR contains many sections, with each section highlighting certain aspect of the business
  4. The AR is also the best source to get information related to the qualitative aspects of the company
  5. The management discussion and analysis is one of the most important sections in the AR. It has the management’s perspective on the overall economy of the country, their outlook on the industry they operate in for the year gone by (what went right and what went wrong), and what they foresee for the year ahead
  6. The AR contains three financial statements – Profit & Loss statement, Balance Sheet, and Cash Flow statement
  7. The standalone statement contains the financial numbers of only the company in consideration. However the consolidated numbers contains the company and its subsidiaries financial numbers.

85 comments

  1. devasia pm says:

    it is very nice for new comer

  2. J V Indudhar says:

    This modules are very helpful and hats-off to the simple explanation thanks a lot

  3. Nikhil Zelawat says:

    Thank you for sharing…nice content for newbiees

  4. srihari says:

    “Well, this is quite simple – CRISIL on its own made a loss of Rs.1000 Crs, but its subsidiary Irevna made a profit of Rs.700 Crs, hence the overall P&L of CRISIL is (Rs.1000 Crs) + Rs.700 Crs = (Rs.300 Crs).”

    In the statement above, I think it must be 1000 crs – 700 crs.

    Waiting for the options module. Thankyou very much for whole material. It is excellent

  5. sugata ghosh says:

    the font size of table/ graphs/ charts are too small…

    • Karthik Rangappa says:

      I suppose you can click on the images to enlarge it. Also, we are working on an e-book format, the images will be much clearer in that.

  6. jaya krishna says:

    thank u very much…..its very simple and lucid explation…..i read ur technical analysis also completly…..its extra ordinary….. hatsoff to u

  7. K Siva Kumar says:

    If we go through every company AR, They all talk about their future in a positive way about their expansions and investments. How can we segregate companies?

    • Karthik Rangappa says:

      Agreed – management is always inclined to talk positively about their company (especially about the company’s future). However a good analyst will be in a position to figure out if the management is being realistic or not. Needless to say, this attribute is a function of experience. Also, always check what the company’s peers are saying in their AR – this will also throw in some perspective. Having said this you would be surprised to know there are companies who are candid about business cycles and the future prospects.

  8. K Siva Kumar says:

    Thanks for reply. I agreed for your answer. Apart from this how can we choose a sector which will do better in this year or a particular period of time like IT did in early 2000s ? What are the aspects should be considered while doing this ?

    • Karthik Rangappa says:

      To figure out which sector is likely to well in the coming years requires a detailed understanding on –

      1) Macro economic situation
      2) Emerging trends within the sector (disruptions if any)
      3) Regulatory overview

      These aspects clearly help in figuring out which sectors are likely to do well in the future.

  9. Michael Mathew says:

    Your Modules are very helpful for a new investor in the market like me .I have a small query,where can a retail investor get a company’s 10 years of financial statements or annual Reports

  10. Sanjeev says:

    Very good content posted for us. Undoubtedly a very good learning for new comers(me). Have one question.
    I am assuming all the companies release their Annual Reports on or before March 31st xxxx.
    Is my assumption correct?
    If yes, will all the long term investors invest from April xxxx?
    If yes, will there be huge volume investing in April?
    Do we see subdued activity in the remaining months from the long term investors?

  11. sudeshnabora says:

    While explaining consolidated financial statement by focusing on the impact a subsidiary has on its holding company.

    I wanted to know, what would be the consolidated financial statement for the subsidiary company (Irevna, for instance).
    Will it have a profit or loss ? (keeping Crisil has a loss of 1000cr and Irevna has a profit of 300 crores).

    • Karthik Rangappa says:

      Usually the company gives out the financials of subsidiary – at least the basic info like revenue, EBITDA, EBIT, PAT.

  12. Srajan Agadi says:

    Thankyou.

  13. chandana says:

    The best platform to get the details knowledge of finance without paying a penny!Hats off to you guys for this social service.Thanks a lot.

    1

  14. Gopan Radhakrishnan says:

    Well explained, just the practical useful part, I found the whole chapter 3 very informative from a new entrant point of view. Thanks.

  15. Abhilash says:

    Like Annual report from company website where do we get Quarterly reports of a company ?

  16. Deepshikha Bhardwaj says:

    God bless you all for taking this initiative. I have a lot of interest in markets and finance, but also the mental block that these were never my subjects. Have tried to attain clarity from various sources, left almost no stone unturned to seek help in learning all this, but never came across anything so clear and simple. Thanks a lot for reviving my hopes.

    • Karthik Rangappa says:

      Glad to hear that Deepshikha! I hope the contents here helps you not in understanding the subject but also identify profitable opportunities.

  17. Ankur Agrawal says:

    Why has amara raja batteries not published its annual report for FY16 till now. It is 9th of july 2016 and the year ended on 31st March 2016.

  18. Vinay Prabhakar says:

    The contents are really helpful. Are there any other organised resources that one refer to??

  19. Ankur Agrawal says:

    If I want to have Annual report of any company in physical form directly from the company, how can I get it?

    Also, Is it mandatory for me to be a shareholder in that company at the time of requesting for annual report?

    • Karthik Rangappa says:

      You can contact the company to get the copy of the AR, and no you need not be a shareholder of the company to get one.

  20. RD3032 says:

    Hi Karthik,
    First off all thanks for your effort to make us educate about the stock market. This chapter talks all about how to analyse and do valuation a company. But my problem is that how can I choose a company among thousands several companies. What was your approach when you chose Amaraja?
    Thanks,
    Deepak

    • Karthik Rangappa says:

      A simple screening technique will help you shortlist companies. You can use sites like screener.in for this!

  21. Rahul says:

    Very soft and simple language used to explain. Much easy to understand, thanks zerodha

  22. Himanshu Pant says:

    You mention the following
    “One example that I explicitly remember was reading through the chairman’s message of a well established tea manufacturing company. In his message, the chairman was talking about a revenue growth of nearly 10%, however the historical revenue numbers suggested that the company’s revenue was growing at a rate of 4-5%. Clearly in this context, the growth rate of 10% seemed like a celestial move. This also indicated to me that the man on top may not really be in sync with ground reality and hence I decided not to invest in the company. Retrospectively when I look back at my decision not to invest, it was probably the right decision.”

    However I find it hard to believe that any chairman for any publicly traded company will lie so outrightly about his company. In other words , don’t the companies take adequate measures to ensure that the various facts mentioned in AR are in sync ?

    • Karthik Rangappa says:

      He certainly was not lying. In fact, when management makes a forward looking statement, it is a reflection of what they expect out of the coming year(s). In this particular case, the expectations were way too much. By the way, this is not too uncommon – look back at management statements from Suzlon, IVRCL etc.

  23. HARI BASKARAN says:

    Dear KARTHIK RANGAPPA,
    i had gone over lots of investment articles to gain ideas and knowledge
    regarding primary and secondary markets through Books, websites, PPTs, PDFs.
    but your collection , composition and presentation can be prasied in a single word
    called “MARVELOUS”. good work sir., keep going,
    Thank you

  24. Raja Sundaram says:

    Wonderful article Karthik. Thank you !

  25. aminravjani says:

    Properly written ..Will definitely go through all of the topics…
    Thank you for all these efforts…

  26. Satyaki Mallick says:

    What will be some good reading material to follow to study and know about companies for Fundamental Analysis ?

  27. Shridhar says:

    Nice very informative

  28. Tanmay Dhar says:

    Hi Karthik Sir,

    Awesome articles. I have never found any article about Fundamental Analysis of such simplicity. Thank you very much for your effort.

    I have one question. How can I make sure whether the management of a company of my interest is good enough to sustain the growth of that company?

    • Karthik Rangappa says:

      Thanks for the kind words!

      Estimating the management is the most difficult thing to do, no straight solution for this 🙂

  29. Sai Sreedhar says:

    Hi Karthik
    Is there a place where we can find the exact time of the result release. Every website only publishes the date but not the time of release.

  30. Shashi says:

    Hi there ,
    What is Indian equivalent of SEC filings in the US. I ask because in US , AR are jazzed up compared to SEC filings. Please advise.

  31. Sunil says:

    Articles are good. I am going through it one by one. Are you having downloadable ebook. As I am new to market I have started to read this articles as per index. But I feel it is better to learn first fundamental then technical. You should have given fundamental topics first and technical articles afterwards. What you think, I am correct or I should understand first technical analysis first.

    Once again thanks for providing this easy to understand and assisting to gain the knowledge of market.

    • Karthik Rangappa says:

      It’s all online Sunil, you can choose to read FA first and then TA. It does not make any difference in my opinion 🙂

      Happy learning.

  32. Saiyed Kamil says:

    In the last snapshot, how is the subscribed capital more than the issued capital?

  33. Sid says:

    Where does the money raised from series-A and series-B funding add up? Does it add up in the issued share capital or paid-up capital or neither?

  34. Sid says:

    Where does the money raised from series-A and series-B funding add up? Does it add up in the issued share capital or paid-up capital or neither??

  35. Sid says:

    Why is issued share capital more than the paid-up capital?

  36. binay says:

    beautifully explained, hatsoff

  37. binay says:

    can we have a chapter on valuation of companies pls?

  38. Nancy says:

    CRISIL making 1000cr losses!!! CRISIL is fundamentally very strong.The hypothetical example was way too much :). Thanks for yet another lovely chapter.

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