AUTHOR: Rama Krishna Vadlamudi vrk_100@yahoo.co.

in
MUMBAI
September 12th, 2006

FOR REGULAR UPDATES ON AUTHOR'S DOCUMENTS: JUST CLICK

www.scribd.com/vrk100

OR
http://groups.google.co.in/group/random-thoughts-on-investments/files?hl=en&&sort=date
HOW AND WHAT TO READ FROM COMPANIES’ ANNUAL REPORTS

Annual Reports provide a lot of information to a variety of people. They play an

important role in making investment decisions. We enclose a study of annual reports and
details about what to look for in annual reports.

Annual reports often conceal more than they reveal. Yet they are perhaps the
best way to tell if the companies you are invested in are up to any good. Annual reports
are designed to satisfy the needs of existing shareholders, potential shareholders,
creditors, economists, financial analysts, suppliers and customers. Financial statements
are the heart of an annual report. Financial statements include a Balance Sheet, Profit
and Loss account, Cash Flow statement, schedules forming part of the balance sheet
and accompanying notes. Other important sections in an Annual Report include
Management Discussion and Analysis, Chairman’s speech, Directors’ report, Auditors’
report, Corporate Social Responsibility statement and Report on Corporate Governance
and other shareholder information.

The standard of disclosures in India can be assessed at many levels-timeliness,

extent and quality of information. Many market players feel that on each of these
parameters, the quality of disclosure falls short of the desirable. No doubt much progress
has been made since the early 1990s. The volume and quality of disclosure have
improved since then, but the problems confronting the analysts have hardly been
addressed. The lack of standardization, the delay, the withholding of information and the
substandard analysis by managements confront analysts and their assessments can be
only be as good. Many feel that there is considerable scope for improvement.

By quantifying the quality of disclosures, one can assess the performance of

companies. Good companies give valuable information to the shareholders, even though
such information may not be mandatory. For the year 2005-06, many companies have
dispatched their annual reports after the closure of the financial year. (For many
companies in India, the financial year ends with March every year.)

When we receive these reports, we are tempted to put them aside or pass them
straight on to a garbage can. Many investors do not care to leaf through them. If one
goes through the reports, one can have a fair idea about the company’s strengths,
weakness, opportunities and threats, which will enable investors to take informed
decisions about a company’s future performance.

Sometimes, there is no uniformity in disclosures. For instance, HDFC Bank

discloses information on wholesale banking, retail banking and treasury. In contrast,
Canara Bank discloses information on treasury and banking operations. Infosys
discloses information on various verticals while Satyam does not disclose segment-wise
information. Reliance Industries divulges the free cash flows generated by each
segment. Few big companies disclose free cash flows of each and every segment.

Let us now try to find some key takeaways from the annual reports:

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 2 of 9

 MANAGEMENT DISCUSSION and ANALYSIS (MDA)

In MDA, a company’s management explains significant changes from year to

year in the financial statements. Although presented in a narrative format, the MDA may
also include charts and graphs highlighting the year-to-year changes. Management
gives its analysis on the past performance and future outlook for the company.
For example, Grasim Industries had given a detailed examination of the
company’s past performance and future outlook in its 2005-06 Annual Report. The
company, in its Annual Report, revealed that their Cement business had been the key
driver of revenues and earnings, whereas, the VSF and sponge iron business had not
done well during the reporting period. The company is ramping up its capacity by 95 lakh
tones per annum (TPA). The company had identified the following risks that were
affecting the company: Economic risk (through margin pressure), foreign exchange risk,
interest rate risk and commodity price risk. The discussion also outlined the steps being
taken by the company to mitigate these risks.
In the ‘Management Discussion and Analysis’ section of its 105th Annual Report,
the Management of Indian Hotels outlines an overview of Global Tourism Industry,
Indian Economy & the Tourism Industry, the company’s sources of Competitive
Advantage, opportunities and threats faced by the company and an Update on Key
Initiatives taken by the company to make the best use of the current buoyancy in Hotels
Industry. The analysis lists out major risks and concerns for the company and the risk
mitigation initiatives taken by the company. With the help of such open discussion about
the company’s outlook, scrutiny of a company’s fundamentals and valuation becomes
much easier.
At the end of Management Discussion and Analysis section, companies usually
give a cautionary statement stating that the statements given may be ‘forward-looking
statements’ and actual results could differ from those expressed in an annual report.

PROFIT AND LOSS ACCOUNT

It is a very important document in an annual report. And it certainly has the most
immediate impact on a stock price. The profit and loss account gives vital information on
the operations, profitability and growth of the company. It summarizes the financial
year’s operations of a business in the bottom line, which after accounting for every
expense could be either a profit or a loss. The important components are given below.
Total Income: The first item in a P&L account is sales revenue. It indicates whether or
not the company is growing. If revenues are growing rapidly, it is a clear signal that the
company is doing well. However, this has to be seen in the light of profitability and
efficiency of operations also.
Other income: It is so called because it does not arise out of the main business of the
company; it includes profit on sale of asset, insurance claims, dividends received from
subsidiaries, and income that cannot be included in sales revenue.
Expenses: Cost of production and other expenses are detailed here.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 3 of 9

Interest: Interest paid on borrowings is shown here. One has to see whether interest cost
is increasing. In general, when companies are expanding, they show higher interest
cost, due to higher level of borrowings. Interest cost has to be seen in relation to PBIT
(Net profit before Interest).
Interest Coverage Ratio: A ratio used to determine how easily a company can pay
interest on outstanding debt. The interest cover ratio tells us the safety margin that the
business has in terms of being able to meet its interest obligations. That is, a high
interest cover ratio means that the business is easily able to meet its interest obligations
from profits. Similarly, a low value for the interest cover ratio means that the business is
potentially in danger of not being able to meet its interest obligations. Interest cover ratio
is calculated by dividing a company’s Profit before interest and tax (PBIT) with interest
paid.
For example, the interest paid by Tata Motors for the year 2005-06 was Rs 293
crore and its PBIT was Rs 2,344 crore, giving an interest cover of eight times, which is
considered good. Whereas Satyam Computers’s interest cover is a staggering 436
(2005-06), indicating that the interest cost is very low compared to its earning before
interest and taxes. Another extreme case is Hindustan Construction Company, whose
interest cover ratio is just 2.62 (2005-06), which shows that the company’s ability to meet
its obligations is under pressure.
Depreciation: An increase in fixed assets also raises the depreciation expense.
Depreciation is the amount written off as expenses for the use of the plant and
machinery, but it involves no cash outflow. Over time, due to normal wear and tear the
value of a plant/physical assets depreciates, which if not provided for will skew the true
picture of a company’s financials.
Taxes: Income tax is to be paid if there is a profit after providing for interest and
depreciation. A company that pays tax can only do that if it has enough cash to meet this
expense. Regular tax outgo is an indication that the company is generating real profits to
give a part to the exchequer. Although there are many factors that make up stock
valuation, a steady tax outflow undoubtedly propels valuations.
Final appropriations: The last part of the P&L account depicts how the board of directors
distributes the net profit. First among the items is the dividend to be paid to
shareholders. In fact, one can compare the amount of the total dividend to be paid with
the net profit to give dividend payout ratio (DPR). A high DPR and a healthy growth in
net profits and revenues signifies that the company is in a healthy financial position.

BALANCE SHEET
A Balance Sheet is a statement of the financial position of a company as on a
specific date. Usually, a Balance Sheet provides information as at the beginning of a
financial year and as at the end of the financial year, so that readers can analyse the
changes that have occurred during the financial year. A balance sheet is divided into two
halves, Asset and Liabilities. In the standard accounting model, the total of assets is
equal to liabilities. As such, both halves are in balance. They are in balance, because,
from an economic point of view, each rupee of assets must be funded by a rupee of
liabilities. Every time the stock market booms investors flock to it, thinking they can make
quick and easy profits out of the stock market. They just look at the net profit figure and

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 4 of 9

get impressed by any growth in the net profits. In such situations, investors ignore the
overall financial strength of the company.
One needs to see how the company made such high profits and how the
company uses the resources available at its disposal. Many a time, investors concern
seems limited to profits-not how they are generated or whether the tempo will be
maintained in bad times.
To avoid such mistakes, one needs to look at the balance sheet. It tells us how a
company used its financial resources in the preceding year. Its study over a period of
time gives enough insights about what lies ahead for the company. Information on a
company’s ability to finance future growth, extent of financial liabilities and utilization of
resources all lie in the balance sheet. These provide insights about the past functioning
of the company and how prepared it is for tough times-the real test of whether revenues
and profits can be sustained. The balance sheet is a record of capital-how it is raised
and deployed. A company can raise money from two sources: long-term sources or
funds that can be repaid over a period, and short-term sources or funds that have to be
repaid within a financial year.
Shareholders’ funds (equity capital plus reserves) and borrowings are long-term
funds. And they are mainly used to finance fixed assets. Considering the long
repayments schedule these are funds carrying a cost. The cost is in the form of interest
(for lenders) and dividends and capital appreciation (for shareholders). If not controlled,
this cost could play havoc with the fortunes of the company.
Borrowings: Borrowings have a fixed cost, interest, incurred irrespective of whether
revenues increase or decrease. This is the reason why they need to be controlled. High
borrowings in relation to the shareholders’ funds also deter lenders to provide fresh
loans. Let us say a company has revenues of Rs 100 crore and its material cost is Rs 60
crore, while depreciation stands at Rs 8 crore. If the interest cost is Rs 12 crore, the
profit would be Rs 20 crore. If revenues decline by 20 per cent to Rs 80 crore, the
material cost would follow suit and come down to Rs 48 crore, but depreciation and
interest cost would remain at previous levels. Profit would then be Rs 12 crore, a drop of
40 per cent.
Equity: Many think that this is free money. Its cost is related to the dividend policy of the
company and its performance, which ultimately tells on the stock price of the company.
But many companies have incessantly raised money from shareholders, arguing that
borrowings would hurt the bottom line. In order to extract the most many wait for the
markets to move up so they can raise fresh equity (through rights/public issues) at hefty
share premiums. ICICI bank and UTI Bank have raised equity through public
issues/GDR in recent years.
Retained earnings (reserves): Ideally one should look for companies that manage
growth primarily by ploughing back profits. If reserves are strong they could also be used
to retire debt and reduce the interest burden. Ploughed-back profits are shown as
reserves in the balance sheet and are residual profits after distributing dividends.
Unlike interest cost, they do not affect profits. At the same time they do not lead
to equity dilution. This money is kept aside to finance the future needs of a business.
Ideally a company should finance it future needs through reserves, unless the
requirement of funds is large enough to necessitate fresh borrowings or shareholders’
money.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 5 of 9

 Many companies, in recent years, have cleaned up their balance sheets through
corporate debt restructuring. For example, companies like, JSW Steel, Essar Steel, etc.
had taken advantage of CDR mechanism offered by creditor banks and brought down
their debt levels considerably.

Current Liabilities: Current liabilities are short-term funds that cater to the working
capital needs of a company. These funds are in the form of credit purchases and short-
term loans, which are extended by the suppliers.

Current assets: Working capital or current assets fund the day-to-day operations of a
company. A company cannot wait for the payment expected in lieu of the goods
previously manufactured and sold. It has to maintain a stock of raw materials and
finished goods to ensure that the production cycle is running continuously. Similarly,
credit sales have to be provided for. Additionally, some cash is required for day-to-day
expenses. Current assets, unlike fixed assets, get converted into cash at periodic
intervals in a financial year.
Fixed Assets: Fixed assets are plant, machinery and building. By their very nature these
are immovable assets with a long life span. Importantly, they are the revenue-generating
assets of a company. They process the raw material and produce the finished products,
which the company sells and earns a profit from.
Investments: Many companies invest their surplus funds till they find a suitable use for
them. They could then be invested in either creating more fixed assets or augmenting
the working capital. Sometimes, they go for acquiring other firms within the country or
abroad. Recently, a lot of companies have acquired foreign companies; for example,
Tata Tea, Dr.Reddy’s Labs, Ranbaxy Labs, etc. These assets do earn a return for the
company. These investments could either be in the form of short-term funds (for
example, liquid mutual funds or short-term fixed deposits) or kept in medium term
instruments. But if investments are maintained at a high level and form a major chunk of
the total funds, it is a cause for worry. The point is that if the core business is not in need
of funds and the same condition is expected to prevail in future, this money can be given
back to the shareholders. It should also be kept in mind what rate of return these
investments are contributing to the balance sheet. Market value of investments of
investments held by such companies as ICICI Bank, IDBI, IFCI, Tata Investment
Corporation and a number of companies and a number of non-banking finance
companies is vital in putting value to their stocks. This information is available only once
a year, making the investment decision a bit tricky. Exide industries had acquired ING
Vysya Life Insurance for Rs 257 crores (at cost) as per 2005-06 balance sheet. Bajaj
Auto has an investment of Rs 496 (at cost) crore in ICICI Bank and Rs 193 crore in its
two insurance companies as at the end of March 2006. Its total investment book stands
at Rs 5,857 crore as at the end of March 2006.
Human capital: Another item that finds a place nowadays in an annual report is human
capital. Here, human capital is not merely one component of capital; it is the critical
component that forms the basis for other forms of capital: People with their expertise are
the sole creators of value to the customer and people through their effort are the key to
the optimization of its process efficiency. Human Capital is defined as the set of skills
which an employee acquires on the job, through training and experience, and which
increases that employee's value in the marketplace. Human resources valuation has
remained an academic exercise and largely ignored even in industries where the
expertise of employees is the key differentiating factor.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 6 of 9

 Software major Infosys Technologies has estimated the value of its human
resources of 52,715 employees including both delivery and support staff at Rs 46,637
crore for fiscal 2006. This represented a growth of 65 per cent over the previous year's
Rs 28,334 crore, when the company had a total headcount of 36,750. The evaluation is
based on the present value of the future earnings of the employees and on the
assumptions of employee compensation including all direct and indirect benefits earned
both in India and abroad.

CASH FLOW STATEMENT

Companies need to deal with various entities during the course of their business,
which may result in financial transactions. But, to do so, the company needs cash.
Hence, it is essential for companies to improve their respective cash generating abilities.
Better management of these cash inflows and outflows and its respective short and long-
term obligations translate into an impressive cash flow statement.
What is a cash flow statement? It generally reflects how a company has generated
cash during a given period, in most cases 12 months, and how it has been deployed for
its core operations, and financing and investing activities. It consists of three parts.
These include net cash flows from:

Operating activities (net profit plus depreciation minus increase in net working capital
minus interest and direct taxes paid)

Investing activities (sale purchase of fixed assets and investments, loans to/from
subsidiaries and investment income)

Financing activities (issue of equity/preference capital, loans taken/paid back and
dividends)

The cash flow statement could be called a perfect X-ray of the financial transactions
of a company. In other words, that a company churns huge profits does not necessarily
indicate its good health. And it may also not be generating enough cash to service its
shareholders with dividends.
Operational cash flows: Huge profits need not mean good health-they could be blocked
in inventories and receivables, and the company could actually be cash strapped.
Sometimes, companies report higher sales by dumping finished goods to its dealers at
the fag end of the financial year.
Going by the profit and loss account alone, not many would have resisted investing
in the stock. There are several instances where companies report negative cash flow
from operating activities, by artificially raising inventories and other current assets. Cash
generation from operations would be a much better tool if taken as a proportion of its net
sales-the higher the percentage, the better. In other words, a company that generates,
say, Rs 10 crore of cash on sales of Rs 100 crore is much better placed than a company
that generates Rs 5 crore on similar sales.
Investing cash flows: The other important sections consist of cash flow from investing
activities and financing activities. Cash flow from investing activities reflects how the
company has deployed its resources in fixed assets, investments (equity and debt),
loans to/from subsidiary companies as well as receipts in the form of investment income
and sale of fixed assets and investments. Generally, the figure of cash flow from
investing activities is negative; that is, there is usually a cash outflow mainly on account

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 7 of 9

of creation of assets, as companies have to make investments to maintain future growth.
Besides, like most individuals, companies tend to set aside some funds for investment
purposes, which form the other sources of income for the company.
Financing cash flows: On the other hand, cash flow from financing activities consists of
funds raised through issue of equity/preference capital, loan taken/paid and dividend
paid, among others. The ingredients of this section are basically the outcome of the first
tow sections (cash flow from operating activities and from investing activities). In other
words, if the company is a good generator of cash, it becomes capable of financing its
investing activities. It would also be in a reasonably good position to retire its debt and
pay good dividends. Thus, an outflow of cash (with respect to financing activities), by
way of debt repayments and dividend payout, would be a healthy sign. Similarly, a
company not capable of generating sufficient cash so as to fund its investment activities
will, in most cases, be seen raising funds (equity as well as debt), much more than the
quantum of outflow in this section.
Net cash flows: The aggregate of the three sections (cash flow from operating, investing
and financing activities) is the final output, known as net increase/decrease in cash and
cash equivalents. Companies that manage their cash flows efficiently generally end up
with a positive figure.
FREE CASH FLOW: In stock valuation, most analysts prefer using discounted cash flow
(DCF) technique to value stocks, in stead of the traditional tools such as, price-earnings
ratio or price-book value ratio. To calculate DCF, one need to have details relating to
fresh cash flows, that is cash flow from operations adjusted for investments in fixed
assets, working capital and the level of debt raised by the firm. Such information is
however available only once a year, and often at considerable lag. Without timely and
regular access to information on free cash flows, opinions tend to be based on multiples
such as, P/E ratio or P/BV ratio. These are only proxies. Many experts consider an
analysis based on P/E ratio and P/BV ratio as irrational compared to the one that is
based on discounted cash flow, which is rational.

CHAIRMAN’s SPEECH

This is where the “vision thing” happens. The Chairman’s speech should ideally
reflect actions and plans for the future. The chairman talks about the general direction of
the company and the industry, sometimes the economy. He usually makes this speech
at the company’s annual general meeting, which is often published as an advertisement
in newspapers and magazines. Sometimes, they provide the occasional insight.

For example, Mr A.M.Naik, Chairman of Larsen and Toubro, talks about

implementation of the company’s strategic plan for five years, starting from April 2006.
The Chairman foresees opportunities in defence, nuclear and aerospace industries. He
further says that they have identified the Middle East and China as prime centers for
international expansion. He recognizes acquisition and retention of talented people as a
key challenge facing the company. Mr Rahul Bajaj, Chairman, Bajaj Auto, outlines his
vision (by 2010) for his company as: (i). Supplying four million motorcycles per year; (ii).
To become largest producer of two-wheelers; (iii). To ramp up Bajaj Auto Finance’s
operations to fund the growth aspirations and (iv). To expand the life and general
insurance business across whole of India.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 8 of 9

 DIRECTORS’ REPORT
Usually, this report contains info about the performance of the company for the
year to which the report pertains to. If the performance is bad, the directors are likely to
give reasons for the same and vice versa. Directors usually declare dividends in this
section of annual report. Segmental reporting is also given here. Capacity utilization, in
case of manufacturing companies, is divulged.

AUDITOR’s REPORT
This can be most boring part of an annual report. In most cases it will merely
state that the profit and loss account and balance sheet give a true and fair view. But it
can also tell us if the management is up to any unacceptable or unethical accounting
practices.
Sometimes, companies do not make provisions for certain exigencies.
Sometimes, the companies change accounting policies, which make comparison with
prior period performance less meaningful.

MISCELLANEOUS INFORMATION
Apart from the above details, companies can also provide a host of other information
that can influence one’s investment decision. These include number of employees,
shareholding pattern, risk management and market information.

Risk Management: Infosys Technologies’ annual report lays out the perceived risks the
company is facing and how the management plans to tackle them. Such openness has
helped it get a superior discounting, even to other high-performance software stocks.

Market information: This includes stock exchange information such as book closure
date, record date for dividend, percentage of shares already under demat, price
performance of shares listed outside India (like GDR and ADR).

Annexure to the directors’ report: It tells, among other things, us about the salaries the
company’s executives are being paid.

FINANCIAL SUMMARY
This includes the company’s long term past performance.

Fundamental data: Many companies give financial data for the past 10 years. Things
covered under this include equity capital, net worth, sales, EPS, dividend, book value,
etc. But, some companies give info about for five years only.

Technical data: Some companies even give share price data for the past one year.

Rama Krishna Vadlamudi, MUMBAI. vrk_100@yahoo.co.in. Sep. 12th, 2006 Page 9 of 9