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Interpreting Company Annual Reports

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Every Limited Company prepares an annual report on its accounts and state of affairs. The annual report comprises : -

Notice of Annual General Meeting
Chairman's statement
Director's Report
Auditors Report
Balance Sheet
Profit and Loss Account
Notes on Accounts.

Understanding or reading a balance sheet implies analysis and study of the balance sheet i.e., financial accounts of a company, with a view to knowing about the company's financial health, its intrinsic value and hidden risks or strengths. It is reading the unwritten. Reading a balance sheet is an art as well as a science and its perfection comes only when science and art both are blended. The science is study and analysis of balance sheet items and profit and loss account through various techniques including ratio analysis and the art is taking out inferences and decisions on the basis of the former.

Notice of Annual General Meeting (AGM): - All special resolutions that are sought to be passed at AGM require explanatory statement. These are drafted in non-legal language giving the rationale or background to special resolutions sought to be passed. Investors should go through the explanatory statement carefully.

Director's Report: - Director's report is a report submitted by the directors of a company to its shareholders, appraising them of the performance of the company under its direction. It is an exercise of self-evaluation. Director's report expresses the opinion of directors on the state of the company, explains performance and the financial results, discusses company's plans for expansion, diversification or modernization, tells about appropriation of profits, elaborates company's future prospects and plans for investments. It is a synopsis of the company's activities during the year and during the interim period between the date of the balance sheet and date of the annual report. Director's report should take the investors into confidence by providing useful insights into the activities of the business, more than what the financial statements provide.

Director's report is valuable and if read intelligently, gives the investor good sense of company's working, its problems and future prospects.

Chairman's statement: - It is an important medium through which company's management communicates with its shareholders, prospective investors and others interested in the performance and prospects of the company. Highlights of the company's performance, future plans, industrial relations, company's position in the industry, research and development efforts, etc. Investors should make a thorough study of such statements.

Auditors Report: - Every company is subject to audit and an auditor makes a report to the members of the company on its state of affairs. It is a comment on accounts and on balance sheet and profit and loss account and other documents attached to the financial statements, which are laid in the AGM. Auditors report to shareholders contains an opinion as to whether the financial statements present a true and fair view of the state of affairs of the company, in case of a balance sheet and of profit or loss in case of profit and loss account. They also report whether the books of accounts are in agreement and whether there is any deviation from generally accepted accounting principles. It indicates the areas to which shareholders and investors must give due attention while assessing the financial strength of the company whose securities are being considered for investment. 

Annual Accounts:- According to section 210 of the Companies Act, 1956, the Board of Directors of the Company shall at every annual general meeting, lay before the company-

Balance Sheet as at the end of each accounting year which is generally the financial year.
Profit and loss account for that period.

These financial statements are prepared to know the financial results of the company and provide information on financial position, performance and changes therein that are useful to various segments of the society such as present and potential investors, employees, suppliers, creditors, lenders, customers, Governments, banks and others.

Balance Sheet: - Balance sheet reflects the financial condition of a business at a given point of time and it contains the aggregate figures of assets and liabilities under various heads. It shows the sources of funds which a business has and the uses to which these funds have been applied.

An investor should look for the following in a balance sheet:

Net worth This indicates the size of the company in terms of the wealth that it owns.

Reserves to equity ratio Indicates the inherent Reserves and strength of the company. However, "revaluation resources" and "share premium" which are not in the nature of "earnings ploughed back" need to be excluded.

Debt/Equity ratio A very high or a very low debt/equity ratio are both not very positive indicators. A high debt/equity ratio, (say beyond 1:5 for most industries) would signify heavy borrowings which would then need to be analyzed in respect of the uses of the borrowed funds-Has the money gone to a fund losses, to the fund working capital or to build or to build assets?

A very low gearing (Debt/Equity ratio) could indicate either a very passive management which is not making the shareholders funds work hard enough or could indicate a situation where costly equity funds have been used, in lieu of cheaper debt funds to fund the company's business which once again would not be very healthy for the company in long run.

Quick ratio Current Assets (except loans and advances)/current liabilities (except tax provision). This ratio does remain one of the important indicators of the short-term solvency and liquidity of the company.

Fixed assets Look out for hidden resources say, in the form of land/building not currently in use by the company (say residential premises) where the book value is substantially below the current market value. Likewise watch out for intangible assets such as goodwill and assets taken on hire-purchase which are, strictly speaking not owned by the company, as yet.

Investments In case of investments in quoted instruments, the difference between the market value and the book value would represent hidden profit/losses which need to be considered.

Loans and advances Large loans given to group companies or subsidiaries, etc. could indicate diversion of company's funds into uses which may not be generating suitable returns.

Miscellaneous expenditure (to the extent not written off or adjusted) This head is increasingly becoming the favorite playground for the creative accountant where expenses with debatable future value (such as launch advertising or research expenses) are parked.Hence this head would also merit closer scrutiny by astute balance sheet readers.

Schedules Schedule to accounts contain details and information which cannot be conveniently included in balance sheet. Schedules are annexed to main accounts and they act as the storehouse of information so essential for a critical examination of the financial strength of the company.

Profit and loss account: - It contains the statement of profitability for a certain period taking into account the revenue,  the aggregate of income generated through sales as also other sources, earned by business during that period and the expenses incurred in earning the revenue. The excess of income over expenses is profit and excess of expenses over income constitutes loss. Profit and loss account also gives gross profit, net profit, profit before taxation and after taxation and appropriations for provisions for dividends and other.

The particulars are to be as per Schedule VI of the Companies Act clearly disclosing the expenditure under four broad heads:

Operating or manufacturing expenses, administrative expenses, selling and distribution overheads and financial expenses.

Operating profit is arrived at by deducting all expenditure except interest, deprecation and tax from net sales and value of stock. Profit less depreciation is Profit before tax.  Cash profits can be arrived at by adding depreciation to net profit. The dividend distribution is done out of net profits and the balance is carried over to reserves. It should be checked whether the dividend has been paid out of current profits earned out of business or other income or reserves.

Gross profit and operating profit margin should also be studied in Profit and loss account. The operating profit divided by net sales would give us operating margin. Gross margin is the gross profit as a percentage of net sales. If operating margins are high, we can say that company's operations have become more efficient. A fall in margin would reflect increased costs or reduction in selling prices of products.

Cash flow statement: - Balance sheet and profit and loss account prepared on the basis of accounting norms and principles contain certain non-cash items. It is sometimes difficult to evaluate the liquidity strength of a company. An analysis of cash flow statement tells us what is the company's cash earnings, how the company is being financed and how the company is utilizing its funds. It reflects the cash sources and their application and shows how the deficit has been financed or where the excess cash has been parked. Investors should examine the flow statement as it tells where the funds have come from and how it has been utilized the statement begins with cash in hand at the beginning of the year. To this are added sources and amounts of funds received and closing balance of cash sources is arrived at by deducting the application of funds.

Thus, it can be said that the annual report is a document containing the blue print of company's business activities, performance and financial indicators alongwith management's and auditor's attestation - perhaps which can not be overlooked by a sincere investor. 

Sanjiv Agarwal

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