News from The Globe and Mail
It pays to inspect annual reports
Saturday, May 17, 2003
A tribute to the relevance of the annual report in this age of instant information can be found in the story of money manager Irwin Michael and the Canada Bread Co. Ltd. shares he sold recently.
Canada Bread has for years been a favourite of Mr. Michael, who runs the ABC family of mutual funds for high-net-worth investors. Then he read the company's 2002 annual report, which was issued earlier this year.
What he found was something that is extremely disappointing to a value investor such as Mr. Michael. As part of a transaction in which it bought a bakery operation from its parent, Maple Leaf Foods Inc., Canada Bread had increased the amount of goodwill on its books by a large amount.
Goodwill is an intangible asset that arises out of a company's reputation, strong brand names and such -- and in the case of an acquisition, it is typically accounted for by the difference between the purchase price and the tangible value of the asset if it were to be liquidated. Mr. Michael was willing to live with a little goodwill on Canada Bread's books because of its Dempster's and Tenderflake products, but now the amount of goodwill was beyond his comfort level.
When an opportunity arose, around the same time, to sell Canada Bread stock at an advantageous price, Mr. Michael jumped on it and closed his position.
"The investment business is essentially about one word, which is information," Mr. Michael said. "Annual reports provide a wealth of information."
These days, if you want the most current information about a company you go to the Internet. Annual reports? It's easy to write them off as a relic of bygone days when they were often the only link between a publicly traded company and its shareholders and prospective shareholders.
Mr. Michael acknowledges the usefulness of the Internet and other sources of information such as brokerage reports. Annual reports are special, though.
"The annual report provides a plethora of information about a company from the company's own financial people," he said.
The question is, how do you find and interpret this data? Mr. Michael knows what to look for because he has an MBA and a chartered financial analyst designation, but what if balance sheets and consolidated statements of income are as opaque to you as Einstein's E equals MC squared?
You'll have to bone up on reading financial statements to really exploit annual reports, but there are some general guidelines that can help you get significant use out of them.
The first thing you have to know about annual reports is that they're pure puffery, in large part.
"First and foremost, annual reports are really a public relations exercise," said Jason Orr, a faculty member at the Canadian Management Centre in Toronto who specializes in financial literacy. "Company executives are putting their best foot forward. I draw the analogy of an annual report to a first date."
Case in point is the first section of the typical annual report, where you'll find a message from the chairman and/or president, and a section called management discussion and analysis, or MD&A.
Securities regulators are pushing companies to provide more solid analysis in the MD&A, which is good because in its present form it rarely offers anything of use to seasoned investors. That said, the MD&A will be the meat of the annual report for you if you can't make sense of financial statements.
Mr. Orr suggests you read through the management analysis to see how well it meshes with the latest news generated by the firm.
"If you know the company's having trouble in an area and management skips over it or doesn't mention it in the annual report, then that won't give you a real good feeling about the honesty of management," he said.
Other useful information that even the layperson can understand is found in the charts located near the front of the annual report. Often you'll find three- or five-year graphs showing the trend for such important measures as revenue, earnings per share, return on equity, share price and dividends per share.
Next, we come to the real guts of the annual report -- the consolidated balance sheet, statement of earnings and cash flows, plus the all-important notes to the financial statements. Here's a brief explanation of each:
Consolidated balance sheet
What it is: Assets and liabilities as of the end of a company's fiscal year (this is where Canada Bread's increase in goodwill and other intangibles, to $346-million from $126.9-million in 2001, turned up). The surplus of assets after liabilities are applied is shareholders' equity, also known as book value.
What it shows: Think of the balance sheet as a snapshot of the financial strength of a company.
What to look for: It's hard to generalize here, but one thing to keep in mind is that comparing liabilities with shareholder equity will show you the extent to which a company is using debt (short- and long-term borrowings are two key aspects of a company's liabilities).
Statement of earnings
What it is: How much the company made from selling its products or services and how much it incurred in expenses.
What it shows: Whether the company is making or losing money.
What to look for: Were the company's profits, assuming there were any, from core operations, or were they from one-time asset sales or other extraordinary gains?
"A lot of people go right to the bottom line and if the company's profitable, they assume everything's fine," Mr. Orr said. "I would say that the quality of the profit is just as important as the amount of the profit."
Cash flow statement
What it is: Also called the statement of changes in financial position, this section of an annual report tracks money coming in and out of company through operations, investments and financing activities such as share and bond issues.
What it shows: How effective a company is at generating the cash needed to run the business, service debts and pay dividends.
What to look for: The amount of cash coming in from core businesses as opposed to financing.
Finally, there are the notes to financial statements, which are explanations of the estimates, policies and assumptions used in preparing the company's financial statements. The notes can be tough going for some, but there's often much more useful information here than in anything top executives contribute to the annual report.
"I find the most interesting things come in the notes to financial statements at the back of the book," Mr. Michael said. "Presidents of companies want to promote themselves and their companies, so they talk about all the good things in the management report. But figures don't lie."
Investors may soon find a similar level of usefulness in the annual report's management discussion and analysis. The Canadian Securities Administrators, a group representing provincial securities commissions, is working on tough new disclosure standards for the MD&A that could be in place by year end.
The hope is executives will provide a more candid, unvarnished analysis that casts an eye on the future while outlining all information that's relevant. You'll still need to burrow through the numbers to get the most out of an annual report, as Mr. Michael did with Canada Bread.
In that case, Mr. Michael recalled that he had an idea that the company had taken on goodwill from the assets it acquired, even before the annual report came in.
Reading the document crystallized things. "When I saw it in black and white, it was so blatant."
How to receive annual reports
Annual reports are easily accessible through a few different means that differ mainly in how quickly you get the document.
The easiest and slowest way is to call or e-mail a publicly traded company's investor relations department and ask to have a copy of the report mailed to you. If you need contact information for a particular corporation, try the "company snapshot" feature available when you get a stock quote on Globeinvestor.com at http://www.globeinvestor.com .
The fastest way to get an annual report is to download it either from a company's own Web site or the Sedar.com Web site, which is where all regulatory filings are made available. Once you've downloaded the document you can then print it.
Another option is to use the free annual report service operated by a company called WILink. You can order by telephone at 1-888-301-0506, or visit WILink's Web site at http://www.wilink.com . Note that WILink will let you order multiple reports at one go.
© The Globe and Mail