Overview – Understanding an Annual Report
One of the most important documents publicly-traded companies regularly publish is their annual report.
Many of these reports are behemoths, containing hundreds of pages of financial data, management discussions, legal proceedings, accounting changes, and lots of other information.
Despite their intimidating size, investors don’t need to read entire annual reports from start to finish to get the information they need. Most of the time, a few, key sections provide investors with sufficient information to make a decision.
Although annual reports contain a lot of information most investors don’t need, they do contain three very important statements: a balance sheet, an income statement, and a statement of cash flows.
In this article, we will go over each of these three documents, using Toronto-Dominion (TD) Bank’s 2019 Annual Report as our example.
Annual Reports: Labyrinths or Pots of Gold?
To get a grasp of just how much information an annual report contains, take a look at the table of contents of the TD 2019 Annual Report:
At a glance, there doesn’t seem to be a lot of sections. As we can see, the first 12 pages already cover a lot of ground.
However, notice that there is a huge gap between pages 14 to 120. This is because “Management’s Discussion and Analysis” has its own table of contents, shown below:
Now we have a better idea of just how much information an annual report contains.
Many investors have this false belief that you must read annual reports from cover to cover and that failing to do so will lead to some critically important bits of information being overlooked.
Lots of investors do not realize this: not all information in an annual report will affect your investment decisions. The amount of information extracted from an annual report is solely up to the investor.
Perhaps you’ve heard of the 80/20 rule, which states that 80% of outcomes/outputs come from 20% of causes/inputs.
This same principle (though not necessarily the same percentages) applies to investing: almost all the information you need to make an investment decision comes from just a few key sections of an annual report.
What classifies as “key sections” varies from investor to investor: some may focus on the CEO’s message and risk factors, while others may focus solely on the financial data.
Unless you happen to be a polymath with world-class knowledge in finance, accounting, law, government policy, and engineering, chances are you won’t understand every single section. Even if you did have all this knowledge, not all of this information will be equally important to you.
The importance of specific parts of an annual report depends entirely on what exactly you’re looking for.
For example, prospective investors are most likely going to be more interested in the financial performance of the company. On the other hand, a lawyer working for the company is probably more interested in all the ongoing litigation that the company is involved with.
One of the worst things you can do is to read an annual report with no clear goal in mind. By knowing exactly what sort of information you want to extract, you can use your time more efficiently and advance your work a lot faster. There’s no need for you to boil the ocean to get the information you want.
Although investors can pick and choose what information they want to extract from an annual report, there are three important documents within the report that all investors will need to analyze to some degree: the balance sheet, income statement, and statement of cash flows.
The Three Financial Statements
Before analyzing each of the three statements, you may notice that the analysis will be done in a specific order: balance sheet first, then income statement, then the statement of cash flows.
This is not an arbitrary decision. Almost all publicly traded companies present the three statements in this order, and each serves to reconcile the others (more on this later).
Also, negative values on any of the three statements are not reported using the negative symbol. Instead, brackets denote a negative value. For example, (1250) means -1250. This is the convention when preparing financial statements and when reporting financial data.
Balance Sheet
The Balance Sheet, sometimes called the Statement of Financial Position, reports a company’s assets, liabilities, and equity at a specific point in time.
A balance sheet produced on January 1, 2020, will be different from one produced on January 5, 2020. For the sake of simplicity, assets can be thought of as what a company owns, and liabilities are what a company owes.
All the numbers on a balance sheet must satisfy one equation, the accounting equation:
Total Assets = Total Liabilities + Total Equity
Balance sheets have their name because assets must always be equal to the sum of liabilities and equity, they must always balance.
An unbalance means an item is missing, or the balance sheet was put together incorrectly. If you look at TD’s balance sheet above, you can see that balance is achieved: total assets are equal to total liabilities plus total equity.
The accounting equation, put into words, simply means this: there are two ways to obtain assets, either by using debt (liabilities) or by using capital (equity).
Though not shown in the above balance sheet, assets and liabilities can be broken down into “current” and “non-current”.
Assets that can be converted into cash in under a year are classified as current, whereas assets that take longer than a year to turn into cash are non-current.
Similarly, liabilities that are due within a year are current, while liabilities that aren’t due within a year are non-current. Listed below are some examples of current and non-current assets and liabilities:
- Current Assets
- Cash, Accounts Receivable, Inventory
- Non-Current Assets
- Land, Long-term Investments, PP&E (Property, Plant, and Equipment)
- Current Liabilities
- Utility payments, short-term loans
- Non-Current Liabilities
- Bonds, loans with terms exceeding one year
Equity represents the amount of money a company’s investors are entitled to if all the company’s assets were liquidated (converted into cash) and all liabilities were paid off. If you re-arrange the accounting equation, you’ll find that equity, in equation form, is the difference between assets and liabilities.
Equity can also be thought of as the degree of ownership investors and other external parties have in a company.
The primary components of equity are the value of all shares (common and preferred), retained earnings, and other comprehensive income.
Income Statement
Sometimes called the profit and loss statement or statement of earnings, an income statement reports the amount of money a company earns and spends over a specific period.
This period is known as the fiscal year, the 12-month period that a company records its financial data.
A fiscal year is not always the same as the calendar year (January 1 to December 31). For example, a company may choose to begin its fiscal year on October 1, meaning that all financial information is recorded from October 1 to September 30 of the following year.
Whenever you hear companies talk about their “bottom line”, they are talking about their net income (which is usually at the bottom, or near the bottom, of the income statement).
Like the balance sheet, the income statement is centred around a single equation. For an income statement, that equation is:
Net Income/Loss = (Total Revenue + Gains) – (Total Expenses + Losses)
A Net Loss is when total expenses & losses exceed total revenue & gains. This does happen to companies from time to time, though it is clearly not something that should happen regularly.
It is important to note that income statements do not differentiate between cash and non-cash entries.
As a result, this necessitates the existence of the statement of cash flows (more on this in the next section).
That is because virtually all publicly traded companies use accrual accounting: revenue is recorded when earned, and expenses are recorded when incurred. This differs from cash accounting, where revenue is recorded when cash is received, and expenses are recorded when cash is paid.
Therefore, just because a company earns a lot of revenue does not mean they collected that much in cash, and just because a company has lots of expenses does not necessarily mean they paid that much in cash.
Recall that assets and liabilities are subdivided into current and non-current; a company’s revenues and expenses follow a similar classification.
Revenue earned from primary business operations is called operating revenue. TD breaks down its operating revenue by dividing it into interest income (their largest revenue stream) and non-interest income (revenue earned from other business divisions, not related to offering loans).
Revenue generated from non-core business activities is classified as non-operating revenue. Non-operating revenue items tend to be infrequent or one-time in nature. In the above income statement, non-operating revenue is listed as “other income” under the non-interest income section.
Likewise, expenses incurred from earning operating revenue are classified as operating expenses. TD, again, breaks down its operating expenses into interest and non-interest expenses.
Non-operating expenses are costs not related to core business operations. The “restructuring charges” and “other” entries under non-interest expenses would be TD’s non-operating expenses.
Cash Flow Statement
Remember that, because of accrual accounting, just because a company posts impressive net income this doesn’t necessarily mean they earned that much in cash.
Many customers use credit to make purchases (head over to the “Credit” article to learn more about how credit works). Whenever credit is used, a company records the transaction as revenue, however, no cash is earned in the process, at least not yet.
Theoretically, a company could “earn” $1 million in net income, but all that income could be in the form of accounts receivable (cash yet to be collected, an item that shows up on balance sheets when customers purchase with credit), meaning the company collected $0 in cash.
Companies can’t pay the bills or pay salaries with a promise of later payment. All companies need cash on hand to run their daily business operations.
This is where the cash flow statement comes in: it sheds light on the inflows and outflows of cash in a company over a given fiscal year.
Cash flow is broken down into three categories: operating activities, financing activities, and investing activities.
Cash from Operating Activities
Cash from operating activities includes any inflows and outflows of cash as a result of normal business operations.
In TD’s case, operating activities may include the purchase and sale of securities, interest payments, and tax payments.
Generally, changes made to a company’s balance sheet items (cash, accounts receivable, inventory, accounts payable) and special items like depreciation appear in cash from operations.
A company’s cash from operating activities is calculated using one of two methods: direct and indirect. Both methods warrant a more in-depth discussion of accounting, which is beyond the scope of this article. We talk about some accounting basics here.
Cash from operating activities can help paint a clearer picture of a company’s financial health. A company bringing in lots of revenue but consistently very little cash from operating activities is a potential red flag to investors.
Cash from Financing Activities
Every company needs to raise money for continued expansion of the business and to make purchases of strategically important assets. Retained earnings alone cannot finance all a company’s strategic needs, so companies also need to raise money.
Cash from financing activities details where the raised funds come from and how it was spent. Publicly traded companies generally raise funds from two methods: issuing shares (stock) or selling debt (bonds).
Issuing shares or selling debt would appear as an increase in cash from financing activities, assuming investors purchase these securities.
Every company must repay their loans, pay dividends to shareholders (if they choose to pay dividends), and may periodically repurchase their own stock (known as share repurchases); all these activities would appear as cash outflows under financing activities.
Cash from Investing Activities
Once a company has raised sufficient funds, it can begin executing tasks that are of strategic importance.
Companies may choose to purchase more and/or replace existing assets (usually in the form of property, plant, and equipment), acquire smaller businesses to expand their operations, or purchase marketable securities such as stocks.
The cash needed to perform these activities are reported as cash from investing activities. What a company chooses to invest in depends on the nature of its business.
TD’s investing activities normally deal with the purchase and sale of securities. Other companies may choose to invest by purchasing more land and constructing new buildings, such as Costco.
How the Three Statements are Connected
When looking at the three statements, never analyze and focus on just one: doing so will greatly reduce the effectiveness of your analysis.
As mentioned earlier, each of the statements serves to check any unusual activity of at least one other statement.
Let’s start by looking at the balance sheet and income statement.
Any income not distributed to shareholders as dividends becomes part of a company’s retained earnings: the money a company holds onto to be used for some future purpose, such as paying dividends, repurchasing shares, or expanding lines of business.
A company’s retained earnings are reported as part of equity. Therefore, an increase in net income generally leads to an increase in equity, which appears on the balance sheet (there are many other factors that can affect how a company’s equity changes in a given fiscal year).
An increase in revenue shows up on the balance sheet as either an increase in cash or accounts receivable; assuming expenses are constant, this would also mean an increase in equity.
Conversely, an increase in expenses can show up on the balance sheet as a decrease in assets (cash paid) or an increase in liabilities (an increase in accounts payable, expenses that must be paid off at a later date).
Finally, the cash flow statement reconciles both the balance sheet and income statement.
Recall that an increase in revenue can appear as either an increase in cash or accounts receivable. Eventually, the customer must pay the balance they owe to the company: this is reflected by a decrease in accounts receivable and subsequent increase in cash.
The subsequent increase in cash must therefore appear in the cash from operating activities section.
A sudden increase in revenue but relatively stagnant cash flow over a fiscal year may be a sign of trouble since customers are either not repaying their outstanding balances on time or cannot afford to pay them at all.
Statement of Comprehensive Income and Statement of Changes in Equity
You may notice that there are two other statements when companies report their financials. Both statements serve more as a supplement to one of the three key statements, so we will go over each one briefly.
The statement of comprehensive income acts as a supplement to the income statement.
Unrealized gains or losses from assets such as bonds, stocks, and derivative instruments are reflected on the statement of cash flows, but not anywhere else.
This extra income, from an accounting perspective, is not reported in the income statement but is instead reported as “other comprehensive income”.
Comprehensive income is added onto the net income to create a new item: total comprehensive income.
The statement of changes in equity, as the name suggests, goes over how a company’s equity has changed from the start of the fiscal year to the end.
This is normally accomplished by taking the starting balance of some equity item (common shares, preferred shares, retained earnings), listing all adjustments made throughout the year, then reporting the end-of-year equity balance for the given equity item.
Wrapping Up
Annual reports are an invaluable part of any investor’s analysis. They are one of the few documents that help investors truly understand how a company operates.
Despite the wealth of information tucked away in an annual report, not all the information contained is required to make an informed investment decision.
The Balance Sheet, Income Statement, and Cash Flow Statement, along with the supplementary statements of Comprehensive Income and Changes in Equity paint a very clear picture of a company’s past financial performance, current financial health, and future growth prospects.
Taking the time to read, analyze, and understand an annual report and the accompanying statements will greatly increase the likelihood that high-quality companies become part of your portfolio.
