ANNUAL REPORT REVIEW — An investor’s guide to reading the Annual Report

What is past is prologue. — William Shakespeare

Chances are the Bard never had to write an annual report, yet the above aphorism serves as a reasonable explanation as to why this most widely read of financial statements is important to investors.

Whether a company succeeds or fails depends on how its securities fare in the future. And the best way to uncover clues to the future is to examine the past. By learning the past earnings record and current financial health of a company, an investor can decide whether or not a stock is worth his attention.

Which is why the annual report is must reading for any current or potential shareholder. The better informed the shareholder is, the safer he is, especially in the case of junior, high-risk companies.

What is an Annual Report?

Simply put, the annual report is the formal account of the past year’s financial activities and operations of a corporation, government department or agency, or non-profit institution. It is published after the institution’s fiscal year-end and, in the case of a corporation, issued to shareholders.

Not only do such reports have to meet acceptable accounting standards; they must contain information required under provincial securities legislation and federal or provincial corporation laws. In addition, shareholders must receive them within a specified period of time.

Among the other elements obtained in annual reports are:

* the names of directors;

* details of remuneration for officers and directors;

* details of employees and officers’ share purchase plans;

* a list of investments in other corporations wholly or partly owned by the company;

* details of long-term debts;

* information on any lawsuits facing the company, and whether or not profits are likely to be affected; as well as

* a statement on the company’s prospects and plans by the chief executive officer, and an outline of the performance and activities during the past year.

The report is usually printed on high-quality paper, with an attractive cover — often in color. The cover tries to illustrate what the company is all about. In the case of a mining company, this may take the form of a photograph of either the head frame or the underground workings (or open pit) of the company’s main producing mine.

Essentially, most annual reports have three elements: prose, illustrations and figures. While the prose is understandably of a promotional nature, it is also, for the most part, terse and informative. The photos, illustrations, graphs and pie charts go a long way toward making the information interesting and attractive. It’s the figures that tend to be the

most-difficult-to-understand part of the report. These figures are generally scattered throughout the four main sections of the report, namely: * the balance sheet;

* the earnings statement;

* the retained earnings statement; and

* the statement of changes in financial position.

Often overlooked, but nonetheless an integral part of the annual report, are notes to these four sections.

The Balance Sheet

The balance sheet shows the financial picture of the company at a specific date (usually the closing day of the company’s financial year). Included are the assets, liabilities and shareholders’ equity of the corporation.

On one side of the balance sheet (the left side in Canada and the U.S.) are listed the company’s assets. Assets are anything that the company owns or has owing to it. They include current assets (such as cash, short-term securities, accounts receivable, inventories and prepaid taxes) and fixed assets (such as buildings, factories, machinery and equipment).

Note that fixed assets are sometimes referred to as property, plant and equipment. The normal method for valuation of these fixed assets is: cost minus the depreciation accumulated by the date of the balance sheet.

Accountants regard depreciation as the decline in useful value of fixed asset due to wear and tear from use over time.

The other side of the balance sheet shows 1) liabilities and 2) the shareholders’ equity, or the net worth of the company, which represents the shareholders’ interest in that company.

Liabilities are what the company owes others — or, more specifically, all debts that fall due in the coming year and beyond. Included here are current liabilities (such as accounts payable, income tax payable and the amount of long-term debt paid off that year) and long-term liabilities (debts due after one year from the date of the financial report).

Long-term liabilities include not only long-term debts, as such, but also deferred income taxes. This is income tax that would otherwise be payable now, but which is deferred by using certain deductions provided by the government and which are believed to benefit the economy as a whole. Any tax writeoffs in the early years of investment serve to reduce what the company would otherwise owe in current taxes.

On the balance sheet, liabilities are subtracted from assets, and what remains is shareholders’ equity or ownership in the company. In this way, assets always equal liabilities plus shareholders’ equity.

Shareholders’ equity, then, is the total equity interest that all stockholders have in the company. For legal and accounting reasons, it is usually separated into three categories:

* Capital stock, which are the shares representing ownership of the business, including preferred and common;

* Retained earnings, which are the after-tax profits over the life of the company after all expenses and dividends have been paid out; and * Contributed surplus (sometimes called capital surplus), which is the amount raised by the sale of shares in excess of the par or market value of each share;

The Canadian Securities Institute believes it essential that the reader of the report realize that the balance sheet does not show how much revenue a company took in during the year. Nor does the balance sheet show the expenses incurred, nor how much profit was earned or loss incurred. This information is provided in the earnings statement.

The Earnings Statement

What Merrill Lynch calls “the payoff for many potential investors” is the earnings statement, sometimes called the income statement or profit-and-loss statement. This shows how much money a company made or lost during the year from the sale of products or services and the expenses the company incurred for wages, operating costs, etc. The difference between how much was taken in and how much was spent is the net earnings or profit of the company. This is the money that is used to re-invest in the company and to pay dividends to shareholders.

The earnings statement is divided into four main sections:

* the operating section;

* the non-operating section;

* the creditors’ section; and

* the owners’ section.

The operating section lists income from the sale of the company’s goods or services, minus the cost of sales (labor, energy, etc.) This gives you the gross operating profit. In the non-operating section, non-operating income (such as interest and dividends from company investments) is added to the net operating profit. To this is added extraordinary items, which are any unusual and significant additions to income or losses. What you end up with is the company’s remaining income from all sources.

Payments to creditors are listed in the creditors’ section. These usually take the form of fixed interest charges on bank loans and interest charges to other debt-holders who have lent money to company. These payments are deducted from the income of the company.

Finally, we have the owners’ section, which shows the company’s net earnings or deficit. The net earnings are shifted to the retained earnings statement, which shows the total annual earnings retained after payment of all expenses and dividends.

The Retained Earnings Statement

“If the [earnings] statement is the payoff for shareholders trying to discover how successful their company truly is for them, the retained earnings statement is the payoff for the company,” says Merrill Lynch.

This portion of the annual report shows “the a
mount of earnings which have been kept in the business either as cash or reinvested in new assets.” Stated another way, it reveals “the excess of net earnings that have been accumulated by a company year-by-year, over and above dividends paid out to shareholders.”

The earnings statements reveal how much money passes through a company during a particular year. To fill in any gaps as to how a company works, you should check the Statement of Changes in Financial Position.

Changes in Financial Position

This section of the report explains changes in working capital (current assets minus current liabilities) between two consecutive years. It goes by many names (including Source and Application of Funds Statement and Source and Use of Funds Statement), but it basically acts as a bridge between a company’s balance sheet for those two years. It also summarizes how a company raised financings for the year and how those financings were used.

Auditor’s Report

Every Canadian limited company is legally required to appoint an outside, independent accountant to represent shareholders and report to them each year on the company’s business. Essentially, the accountant’s job is to verify the accuracy of the company’s financial statements. The auditor’s report is usually quite brief, and it gives assurance to shareholders that the annual report is a reliable indication of the financial health of the company.