There are more speculators in the stock market as compared to investors. This is evident from the fact that more and more people entering the equity markets during the current rally. There is a high chance that most of these new entrants will exit the markets once they see a significant fall.

 

You will have conviction in a stock you own, only if you deeply understand about the business. This conviction will help you stay sane even if a stock you hold tanks 50%. Such conviction cannot be borrowed, but is developed only through your research. Reading annual reports will help you do so.

 

Let’s look at 5 reasons why you must read annual reports.

 

Get Ahead of 90% of Retail Investors

If you are reading annual reports, you are already in the top 10% of retail investors. Most people who “invest” their money in stocks, don’t even know what the company is doing. They just buy the stock of they liked its name.

 

There were many companies that were very well-known, but in the end these had poor businesses. All this was evident if you had gone through their annual reports. Reading annual reports gives you immense advantage over other investors. It will also help you keep calm even if a stock you hold tanks 50% knowing that business prospects are good.

 

Understand Business Model

Going through multiple annual reports of a company and also the annual reports of competitors will help you in understanding a lot about the company’s business model and the industry. You will also understand the future prospects of that industry.

 

Understanding the business model of any company is very important as almost all your investment thesis will be based on it. It will form the bedrock of your investment decision. It is only after you’ve understood the business model, and it’s future prospects, you’ll be able to better interpret the financials.

 

Study Financials

This is where investors spend most of their time. The three financial statements that you must study are balance sheet, income statment and cash flow statement. You must look at how the company’s financials are placed within the industry.

 

Inside financial statements, there are various notes. You’ll get more insights about the company’s financials if you are going through the notes. From all these financial statements, you must be able to interpret them properly. This will help you in properly analyzing the company.

 

If you are looking for a detailed guide to analyzing financial statements, do check out my guide.

 

 

Check Management Quality

There are many companies that look great from the outside. You can see the case of Satyam or DHFL. Both of these were well known companies, but if you read their annual reports, you would have know what was actually going. And most shareholders were not even aware of it.

 

You can also check what the managment had said a few years back, and check whether they are consistent with it currently — have they achieved whatever goals that they have set? are they consistently changing their goals along with the trend? You’ll get a lot of insights about the management by going through the annual reports.

 

Discover Future Potential

If you’ve read through multiple annual reports, you’ll have a fair idea about the business model and the industry. You’ll know about the financial health of that company. Based on your analysis and the managment goals, you’ll be able to determine whether the company has good future potential.

 

What To Read In Annual Reports?

Now that you’ve understood why it is important to read annual reports, let’s look at what you should look at in an annual report. Since the annual report is a big, bulky document, around 200-300 pages long, sometimes even stretching to 500 pages. Now, it is not feasible to read each and every page. There are a few sections where you should spend the most of your time.

 

The most important part is the Chairperson’s report. Here, you’ll understand his/her outlook about the business over the next year. Another section that is similar is Management, Discussion & Analysis. This goes in more details as compared to the Chairperson’s report. Compare what you read here with what you’ve read in the past annual reports.

 

Then we have the Auditor’s report. Look at what the auditor is saying, and whether the company has given all the data needed to audit the company. Here, you’ll understand about the integrity of the management. Also check related party transactions and contingent liabilities. These will give you an insight whether the mangement is siphoning funds away from the company.

 

Finally, look at the financial statements and its notes. You’ll be spending most of your time here. Check for consistency in numbers. You’ll get a lot of hints as to whether the management is moving funds away from the company. There are various methods which managements use to do this. I have convered this in detail in my financial statements guide.

 

Final Thoughts

Annual reports are the most important document which you should read to analyse businesses. There are many investors who read just the annual reports to take investment decisions — no managment presentations, conference calls etc. — just annual reports. In fact, Warren Buffett also does the same.

 

You’ve understood why reading annual reports is important, and what sections to read within an annual report. I hope this post encourages you start reading annual reports.

 

Till next time.