Ten Tips For Reviewing Annual Reports
October 20th, 2014 - New York, NY
Annual reports can be a valuable tool for investors, but they also may foster unrealistic expectations. Companies, like politicians, can be masters of spin, and annual reports provide a valuable opportunity to paint a corporate picture in the most appealing strokes. Investors need to look beyond the luster, at the company’s performance and potential. In other words, it is important to separate the facts from the fluff.
Annual reports are intrinsically more appealing than the average prospectus or financial report. Why? They generally have pages of pictures and colorful charts. Shareholders get an instant peek at officers, directors, plants and products – in color no less. But appearance is far less important than substance, particularly where investment dollars are involved. A photogenic management team is no substitute for profitability. From an investor’s point of view, a successful business presents the prettiest picture.
What should shareholders focus on when they are reviewing an Annual Report? We offer a few suggestions:
1. It’s Fair to Compare. How does the company characterize the state of its business and its future plans? Take a look at the previous year’s report. Did the company perform up to last year’s expectations or did it fall short? Did the business meet last year’s projections, and were projects started or completed as previously anticipated? If not, is there a reasonable explanation? If a company did not follow through on previous promises, there is good reason to be uneasy about future projections. An annual report offers the company a good opportunity to present its vision for the future, but having done so, it needs to fulfill those goals.
2. The Bottom Line. In the end, every public company is measured by its financial performance. Focus on the financial statements, although they may be the least colorful and most tedious section of the Annual Report. Have revenues been steady, or increasing? If not, is there a logical explanation, or a troubling one? If shrinking revenues were caused by the overall economic environment, and the company remains sound, shareholders may decide to stay the course. They may be far less comfortable, however, if revenues dwindled because the company lost a major customer, or its principal product became obsolete.
3. Cash is King. In the same vein, the financial statements will tell the shareholder how much money the company has available. Has the corporate bank account grown over the past year? Does the company have access to additional financing or lines of credit? In difficult economic times it is important to determine whether the company has sufficient resources to weather a bad year or two and survive.
4. What’s Happening? Does the company’s business have forward momentum? Has it explored new products, new partnerships or promising acquisitions? Is the company warning that it may fail to meet prior expectations? A warning is not necessarily a signal to panic, but it may be a sign of deeper problems. Why does the company plan to fall short of earlier projections? The company should provide an explanation – which may be as simple as the fact that the economy has slowed and sales are down. Shareholders need to review these facts and determine whether the company, or its industry, is likely to recover in the foreseeable future.
5. Explanation for Compensation. Executive compensation has become one of the hottest topics on Wall Street, and with good reason. When the stock market was soaring in the late 1990s, companies did not hesitate to provide generous compensation packages to their top management. High salaries, astronomical bonuses and piles of stock options were handed out like candy on Halloween. It did not seem to matter whether the company was making or losing money, as long as stock prices remained high, investors did not question the exaggerated amounts being handed to corporate leaders.
Revelations of corporate corruption exposed some of the excessive practices that had been lining the pockets of management. That does not mean, however, that every company has abandoned the practice. Review management compensation with care. Have salaries and bonuses continued to increase while revenues have remained steady or dropped? Do existing long-term compensation agreements seem out of step with the current state of the company’s business and revenues? Has there been any effort to renegotiate those agreements – downward – in view of existing conditions?
6. Stability of Management. The annual report should provide detailed information about the company’s officers and directors. Has the management team remained intact? Determine whether any key employees have departed, and how that is likely to affect business. For example, if the principal investigator has resigned from a bio-tech company, has a suitable replacement been hired? Why did the employee leave and what are his or her successor’s qualifications?
These biographies should offer some insight into each officer and director’s prior experience. Have they been involved in the industry for an extended period of time? If not, what skills and experience have they brought to the company? Be wary of a management team that is comprised principally of promoters or former stock brokers who are looking to build the value of the stock rather than the quality of the business.
7. Taking Stock. Has the company issued stock or options in the past year? If so, what has it received in return? Some companies hand out stock in exchange for services – a warning sign that they lack cash. Are options due to be exercised? If they are, that may mean dilution for existing shareholders.
8. Declaring Independence. Has the company established an Audit Committee? Are there Independent Directors? What are their qualifications? Under the Sarbanes-Oxley Act of 2002 companies that are listed on any U.S. Exchange are required to have an audit committee comprised of “independent” directors. To be independent, a director may not be affiliated with the company (other than as a director) and may not receive any compensation from the company (other than as a director).
9. Subsidiaries and Affiliates. Has the company provided detailed information about subsidiaries and affiliates? This is particularly important if a significant amount of the company’s business is constructed through those affiliated corporations. The Annual Report and accompanying financial statements should offer information about those subsidiaries and affiliates, including their revenues, profits and losses. Does the company use offshore corporations as affiliates? If it does, it should offer a reasonable explanation, particularly in light of recent revelations showing that some businesses – Enron in particular – hid losses offshore.
10. Gloss is not Enough. Annual reports may be printed on slick, expensive paper, and can be filled with appealing pictures of smiling faces, sunsets and corporate offices. Try not to be overly impressed by the packaging. Content remains the key. Thumb through the pictures quickly, and take your time reviewing the state of the business, the condition of its finances, and the qualifications of its management team. In the end it’s what is on the page that counts – not the quality of the paper.
The Annual Report is a useful tool, but investors should seek additional information. Check out research reports issued by reliable analysts, review the company’s public filings, and discuss any questions with a trusted financial advisor. As always, before you invest, investigate.
Reference link http://www.stockpatrol.com/article/key/annualreports
About Hartley Bernstein: Hartley Bernstein is a corporate and securities attorney and civil litigator with a specialty in business transactions and civil litigation.