Annual report health check

Do the sums … it only takes 10 minutes for a check-up.
Do the sums … it only takes 10 minutes for a check-up.

Long, boring, self-serving. That's the sentiment most investors profess towards annual reports. No wonder most end up in the bin. And that's where some belong, but not prematurely. Ten minutes spent with an annual report will tell you whether it deserves to be thrown out. Here's my eight-step guide:

1. Find the number of shares on issue

Ignore the glossy pictures and head to the accounts, specifically the balance sheet. Scan it until you reach the ''equity'' section. There you should find a line reading ''issued capital'' or ''contributed equity'' or similar.

To the right should be a number under the ''note'' column. Make a note of it and head to the official notes section after the financial statements. Wade through to find the number of ''fully paid ordinary shares''. Now, multiply this by the company share price. You have just calculated the stock's market capitalisation, the value investors place on the company. Knowing this figure puts the others in the report in context.

2. Who owns the company?

Head to the back in search of the list of ''top 20'' shareholders. Are there any names you recognise? Is it majority-owned by an individual or another company? Has the top 20 changed much since last year? Get a fix on the major shareholders.

3. Who runs the company?

Between the financial statements and the glossy stuff, you'll find the ''directors' report'' listing the directors, their qualifications and experience, remuneration and level of share ownership.

Multiply each director's shareholding by the current share price and then divide the result by their annual remuneration. This shows how many years' pay the director has at stake in the company. Three years is not a bad benchmark. A director's interests should be aligned with all shareholders. A decent-sized shareholding helps.

4. Is the commentary forthright?

Head to the front of the report and read the commentary from the chairman and chief executive. Now, compare it with previous annual reports.

Are the objectives specific and measurable or wishy-washy? Is the writing clear or loaded with management cliches? Do they hold themselves to account to previous promises? Anything worth conveying to shareholders should be clearly expressed. If it's not, that's probably because management doesn't want it to be understood.

5. Check the long-term financial performance

A good annual report will contain a table, usually close to the front or right at the back, showing a five- or 10-year financial summary. Consider the trends in revenue and profits compared with the rest of the industry. Is it cyclical, fast-growing, mature or declining?

Such factors play a big part in judging whether, say, a 10 per cent rise in revenue is an outstanding effort, below par or about right.

The same with profits. Have they been moving in step with revenue, or has the bottom line been growing faster or slower than the top line?

6. Are the accounts qualified?

The auditor's declaration can usually be found towards the back of the report, although sometimes before the accounts. If the declaration is qualified in some way, that spells trouble.

Note 1 to the accounts is always worth a look, too. Pay attention to the policies regarding revenue recognition and depreciation calculations, and keep an eye out for any changes to accounting policies that can be used to boost profits. This is where the trickery is buried.

7. What about debt?

Grab a calculator and turn to the balance sheet. Tot up the long- and short-term ''interest-bearing liabilities'' (that's debt to you and me). Then subtract the cash balance to arrive at the ''net debt'' figure.

Compare the latest numbers with an appropriate point in the past, especially for seasonal businesses such as retailers, which should be swimming in cash after Christmas but hard up beforehand. Has this figure been trending up or down in recent years?

8. Does the profit match the cash flow?

Another good check is to compare the net profit after tax with the free cash flow (operating cash flow less capital expenditure).

If over the long term a company doesn't produce any free cash for its owners, then usually it isn't worth a brass razoo.

This article contains general investment advice only (under AFSL 282288). Nathan Bell is the research director at Intelligent Investor,

This story Annual report health check first appeared on The Sydney Morning Herald.