A full-year results statement is a useful document for understanding how a company has performed over the last 12 months but if you want a deeper insight the annual report is a much more worthwhile read.

You might think annual reports are simply full-year results in a pretty format. In fact, they can offer a huge amount of extra information to help you analyse a company’s investment case.

This includes the company’s position in the market, its risks and opportunities, its long-term performance and its governance. The reports are generally available on the relevant company’s website.

Packed with information

Before you start reading an annual report you might want to make yourself a cup of tea because they can be absolutely enormous. HSBC’s (HSBA) 2016 annual report runs to a whopping 284 pages.

Thanks to the wonders of technology and graphic design, annual reports are often laid out in eye-catching, investor-friendly formats with diagrams and cartoons to help you along the way.

Packaging company DS Smith (SMDS), which won an IR Society award for its annual report, uses a range of infographics to help you understand the business.

There are pictures of its customers’ products to help you differentiate it from other packaging companies. There is also a ‘heat map’ showing the business’ biggest risks and opportunities.

Long-term picture

Hugo Fisher, group communications director at DS Smith, says an annual report provides the reader with a more rounded and long-term picture of the business and its strategy.

‘The full-year results describe the financial performance for that one year – they are a short-term piece of work.

‘The annual report enables you to truly understand the business – its model, the markets it operates in and how it looks at risks and sustainability. It provides more colour around strategy, people and governance,’ he says.

Fisher says the figures used in DS Smith’s annual report are exactly the same as the full-year results statement, but there may be additional operational statistics on areas like service and quality metrics and sustainability measures.

Business context

The quality of annual reports does vary. Some may be simply a collection of sections with no common thread, whereas others are coordinated with all aspects of the business linked together.

Naomi Kissman, head of investor relations and corporate communications at convenience retailer McColl’s (MCLS), which was highly commended for its annual report by the IR Society, says the annual report is a useful way of providing investors with business and market context.

‘The large and growing convenience sector is one of the sweet spots of the UK grocery industry and is not always well understood. Therefore, we feel that it’s important to provide compelling industry context,’ she says.

Kissman believes this information helps both existing and prospective shareholders to have an understanding of where McColl’s sits in the market and the fundamentals underpinning its investment case.

Good introduction to a company

Annual reports are a lot more eye-catching than full-year results statements, but it’s important not to be won over by any flashy graphics.

Nick Davis, fund manager of Polar Capital European Income (IE00BR4SYW82), says the management commentary at the front of most annual reports can give a great overview for people taking their first look at a new company.

Once you’ve got a basic understanding, there is a huge amount of disclosure to help you understand the company’s prospects.

‘As dividend investors, we take particular interest in the cash flow statement and related notes to understand use of cash and sustainability of current dividends.

‘The leases and off balance sheet disclosures are also worth checking to make sure that low optical balance sheet leverage is not misleading,’ Davis says.

The very important bits

Russ Mould, investment director at AJ Bell Youinvest, also suggests looking at the balance sheet, as well as cash flow and profit and loss account – in that order.

‘Companies will try to present their accounts in the most flattering light possible but cash on a balance sheet and the cash flow statement are a lot harder to embellish and flatter than the profit statement,’ he says.

Mould recommends looking at the notes to the accounts because that is where there could be skeletons deeply hidden in cupboards. Gibberish footnotes can be a red flag that the company is trying to gloss over something. Never invest in anything you do not understand.

Most companies that go bust still have cash on the balance sheet and may even be making a profit. The balance sheet will tell you when specific chunks of debt must be repaid, so you can weight that against the company’s other cash needs such as salaries, tax bills and the necessary research and capital investment.

Director salaries and bonuses

The annual report will often contain individual profiles of the board of directors, both executive and non-executive, so you can make sure they have the right skills to help the company thrive.

‘Check out how much money the directors are paid and especially how bonuses and stock options are triggered, to ensure their interests are aligned with yours,’ Mould says.

‘You want them to have to work hard for their readies, not merely reach a performance bar so low that they could virtually fall over it and still cash in.’

Many firms emphasise ‘adjusted’ earnings but there are potential red flags you can look out for. These include frequent restatement of the historic numbers, resetting of the triggers for executive bonuses and a revolving door of non-executive directors.

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