Tips on Reading an Annual Report

Many an investor has felt bamboozled after reading an upbeat “chairman’s message” in an annual report issued by a publicly held corporation.

If the company is doing so well, why is the stock price languishing and the dividend getting cut, some might wonder.

The problem is that consumers often believe that what they see is what they get, industry experts say. And in annual reports, they’ll see all sorts of slick charts and thoughtful prose that indicate that the company is an industry leader--or at least well on its way to becoming one--often without regard to the company’s true financial picture.

Company managers often become highly skilled at putting the bad news in pretty packages. And some shareholders never read beyond the “wrappings,” which in this case are the charts, photographs, drawings and optimistic messages to shareholders. In reality, reading an annual report takes some investigative skills and, sometimes, a touch of interpretation.

Advice from the experts: Skip the first dozen or so glossy pages and get to the meat of the report, where the company lists its revenue, profit, cash flow and expenses. And get out your pocket calculator.

Near the back of the report, the company gives a three- to five-year summary of its operations. Usually this will be an entire page--sometimes two or three pages--of charts.

What do you look for? Ideally, you would like to see stair-step growth in sales, profit and earnings per share during the entire period. (For a bank, thrift or insurance company, substitute “assets” for sales.)

This is where your calculator comes in. Divide current numbers by year-ago figures and subtract one to determine percentage change in all these figures. (For example, revenue is $3,867 million this year and was $4,319 million last year. Plug $3,867 into your calculator, hit the division key and then plug in the $4,319. You’ll get 0.8953. Subtract one, to come up with a negative 0.1046, which equates to a negative growth rate of 10.46%.)

You should also make sure that the growth isn’t caused by a series of one-time events, such as the purchase or sale of subsidiaries, tax credits, accounting changes and the like.

These charts also often show the company’s stock price and dividend history. Again, it’s a good sign when dividends and stock price are rising in a relatively consistent fashion. When a company’s consolidated statement of operations shows great volatility or inconsistent growth, it is usually a warning sign that the risks of investing in that company are relatively high.

Then look for “footnotes.” In a financial statement, footnotes aren’t afterthoughts printed at the bottom of a page in small type. They’re highly pertinent information revealing everything from the company’s accounting practices to the state of its pension plan. Often these “notes to the financial statement” cover several pages of the report. Read them and you’ll find out about litigation against the company, whether the chief executive has been indicted or whether the company has contingent liabilities that could wipe out shareholders’ equity. Stuff you should know.

Also check the auditor’s opinion, which is generally a dull, four-paragraph affair that says nothing more than that an accounting firm has looked over the company’s books and records and believes that the financial statements fairly present the company’s condition. That’s normal. If the auditors fail to give an opinion or note that the company has such substantial contingent liabilities that the auditors “question” its ability to continue as a going concern, it is a danger sign.

Now, if you are still interested in investing in this company, go back to the front and read the chairman’s message. Normally, this letter to stockholders will talk about the company and the business environment. This message should also explain the company’s financial results and say what shareholders should expect. It helps to have previous years’ reports to check the candor and accuracy of the company’s chairman too.

Will properly reading the annual report ensure that you’ll always invest well? Of course not. But it might occasionally steer you away from a troublesome firm.

Consider Los Angeles-based First Interstate Bancorp. First Interstate, one of the nation’s biggest banking companies, in recent weeks announced a corporate restructuring that will savage near-term earnings and lay waste to the company’s dividend.

Were shareholders given a hint of the impending doom by First Interstate’s 1990 annual report? You bet.

The company’s consolidated statement of operations shows that the banking firm’s income and assets have taken a roller-coaster ride in recent years. During the past three years, extraordinary items--business jargon for one-time events--accounted for a significant portion of the firm’s earnings.

In his message to stockholders, the company’s chairman optimistically noted that First Interstate had “made significant progress” and he listed several items that underscored the point. His closing, however, was less upbeat. “As 1990 progressed, we also saw a weakening national economy, decreased loan demand, a slowdown in the California real estate market,” said Edward M. Carson, First Interstate’s chairman and chief executive. “There is little to convince us that these trends will not continue through much of 1991.”