How to analyze an annual report?

Buffett's main source of information for valuing any stock is available to all of us FREE of cost. It is the Annual report of publicly traded companies.

Analyzing an annual report can be a very tedious task. The process of analyzing an annual report can be simplified if you have a ready checklist. This blog post gives a checklist of 25 items. As you go through the report you can keep filling the checklist. Thus by the end , you will have answers to all the checklist points that are applicable to the business.Based on the answers from the checklist , you can list down the factors affecting the earnings and in turn develop the earnings model.Which in turn can help you value the business.

1. How does the business make money – This is basically a 60,000 feet view of the business and should be explained in a short paragraph (not more than 5 lines).

2. Overview of basic Financials for past 10 years : Cash flow , Income statements , balance sheet and stockholder’s equity encompass the basic financials of every company. One needs to have a basic overview as to how these have progressed over last 10 years. For many new companies the data might not be available for last 10 years. In this case whatever historical data is available needs to be considered.

3. Segment Information : Most  Companies have more than 1 reportable business segment. Many a times their results are not co-related. Hence one should try to analyze each segment separately .

4. What are the Factors that are currently impacting the business ?: One can find this information in the Management Discussion and Analysis section of the annual report.

5. Growth model , Capital expenditures and acquisitions.

6. The MOAT : What is the MOAT that the business has that gives it an edge over its competitors.

7. Getting to know the Golden “C” triangle :

(i) Customers: Profile of the customers – individual, institutional, govt.

(ii) Cost structure: Fixed costs vs varying costs.

(iii) Competitors: What’s the market share of the company’s product with respect to its competitors?

8. The selling process – How does the company sell its products? Directly to its customers or through some third party.

9. Pricing power: Does the company have pricing power. In other words can it increase the unit price of its products without impacting its volumes.

10. R&D expense details.

11.How much leveraged is the business.

12. What’s the impact of govt regulations in the business and what’s the risk involved here.

13. Is the business dependent on any government grants or subsidies?

14. Is it a Commodity business? If yes then what’s the volatility in the commodity prices.

15. Are there any long term contracts involved while selling the product ?

16. CASH cycle of the business.

17. What’s the risk involved with any quality issues? Auto industry is one of the great examples of this point where there are many recalls because of which large expenses are involved.

18. How easily are the products replaceable by other types of products? Newspaper industry is a great example of this point where the need of the product itself is shrinking and is being replaced by e-commerce.

19. What’s the spread of business between international and USA operations and the impact of foreign currency on earnings?

20. Is the workforce of the company Unionized? If yes then what’s been the impact to the business.

21. Is the business dependent on any proprietary technology?

22. How is the Tax structure of the company?

23. Does the balance sheet have large amounts of Goodwill and intangible assets.

24. Details of any legal issues company is facing.

25. Pension obligations.

26. Management stability –  How often has the senior leadership and the board structure changed for the company in the past five years.

27. Intricacies of the Financial statements and foot notes – Here one needs to jot down any intricate concepts used in the Financial statements and foot notes that are hard to understand. These especially relate to Accounting methods followed by the company.

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