Every company that is publicly traded or incorporated must file an annual report that gives a summary of its financial history over the past year. The annual report is a useful tool for determining the fiscal health of a company; many persons use this information. For example, a potential lender will look at this report to determine if the company is a good financial risk. Stock analysts use it to predict trends and individuals use it to decide if they want to buy or sell a stock. This research will explain the elements of an annual report and discuss the methods for analyzing it. It will then proceed to take a look at an actual annual report and discuss the results of that example.
A company's annual reports give a snapshot of the company's performance over the past year. It tells bout the company's revenues, expenditures, assets, debts and other information that can be useful in assessing the company's performance. A company's performance is measured by assessing its health in three categories, leverage, liquidity and profitability.1 These factors are compared over time to spot trends and attempt to make predictions as to how the company will perform in the future. In addition the trend analysis, competitors in the same market are identified and the company being analyzed is compared to its major competitors to see if the numbers are normal for that industry or if they are doing better or worse than their competitors. These numbers can be compared to the industry in which they operate and to the market as a whole, such as the DOW Jones, S & P, or the Nasdaq. From the annual reports analysts use a set of ratios, called "ratio analysis," to measure the health of the company as far as leverage, liquidity, and profitability.
Leverage is a measure of the company's assets as compared to the debt that it owes.2 If a company has borrowed a large amount of money to finance new projects or to cover operating expenses, this is weighed against the assets that they have, both monetary and in property, that could be potentially sold to cover the debts. Money borrowed to cover a business expansion is usually seen as positive, as long the company demonstrates that they will receive a good return on their investment, have enough cash on hand to pay the bills when they are due and will realize business growth from this undertaking. Money borrowed to cover operating expenses, except in the case of a new business startup that is yet to turn profit, can be a sign of trouble. It could mean that they are not making enough money to cover their bills. In this case liquidity, or cash flow, must be analyzed to see what the problem is and determine if they have a sufficient plan to regain their position.
Liquidity measures a company's cash flow.3 It analyzes the company's cash flow to determine if they have enough money on hand to cover their short-term debts. If they do not, they may have to take measures that would effect the other factors and either put them in a lowered leverage position or reduce profitability. Liquidity takes into consideration how much is in payables, receivables and inventory levels. It also takes into account how long it takes to turn inventory into receivables. A company can have a temporary cash flow problem and recover. However, liquidity should be examined over time. Often cyclical businesses, such as retail have highs and lows in cash flow that are normal for the industry. However, liquidity should be taken into consideration with leverage and profit growth to determine the health of a company.
Many consider profitability as the only factor in determining a company's health. Every business is in existence to make profit, and to make as much as possible. However, there are many factors that effect profitability measures. For instance, a company may have decreased profits for a short time in order to pay off long-term debts. This may reduce profits in the short-term, but in the future will pay off as expenses will be lower and they will save large amounts of interest. One must not only look at the profitability of a company, but must try to see why profits are the way they are.
Industry comparisons are useful in determining whether a company is in line with others.4 Some industries have typically lower profit margins than others do. For instance the airline industry runs on lower profit margins than the restaurant industry. The airline industry's expenditures are much higher as compared to its revenues as compared to running a restaurant. Profitability must be compared over a period of time to try to predict trends. Then these trends must be compared to its competitors, the industry in which it operates, and the markets as a whole to determine if the trend is due to factors effecting only that company or if they are due to general economic conditions beyond the company's control.
The annual report contains information other than just numbers that can be useful in assessing a company. The numbers are not always the bottom line. The annual report contains executive summaries and explanations of the numbers and gives reasons for trends or anomalies. Th annual report gives explanations of accounting methods used, which may have an effect on the final result. For instance, if a company switches its inventory accounting method from FIFO (First-In-First-Out) to LIFO (Last-In-Last-Out), it can have an effect on their reported revenues and taxes paid before the switch and after the switch.5 When looking at an annual report, one has to read text and not just them numbers. The numbers tell a story, but they may not necessarily tell the entire story.
Leverage, liquidity, and profitability are three factors most commonly used to assess the financial health of a company. Every analyst has their own formulas and methods for determining their criteria for rating a company's performance. They use tools such as ratio analysis, trend analysis, and competitor comparison to make their decisions. What ever method they personally choose, there is one thing in common, their most valuable tool for assessing the health of the company is the Annual report and the accounting information that it contains.
Now let us look at the annual report of a company and discuss its financial position. I chose the Kmart corporation as an example because they just filed Chapter 11 Bankruptcy Reorganization in 2001.6 The 2001 Annual Report gives data for 1999, 2000, and 2001 for comparison.
Using the Consolidated Statements of Operations tells is about the profitability ratios of the company. In the 2001 Annual Report we can see that from 1999 through 2000, Total Sales increased and then decreased in 2001.7 At the same time the Cost of Sales increased at a steady rate. Gross margins steadily decreased as well. Net income went from small profit in 1999 of $403 million to a major loss of -$2,418 million in 2001.8 This clearly shows a pattern for trouble. Increases in sales revenues did not keep pace with increases in costs. This made them show a negative profitability in 2001.9
The Balance street tells us about leverage ratios, assets to liabilities.10 The Current ratio (Total Assets/Total Liabilities) shows that in 2001 and 2000 they are exactly equal, making the current ratio 1.11 This is a complex accounting trick and therefore, in this case the current ratio is meaningless. If one will notice, the amount of assets in invested decreased, while the assets in cash increased. This would lead us to believe that they sold inventory to turn it into cash.
One will also notice a reduction of long-term debt.12 If we looked at the Balance sheet alone, then we could conclude that the company is in good shape. It has no long-term debt, and has an equal number of assets to liabilities. However, if we read the Manager's Discussion and Analysis we might change our mind. He says,
As a result of a rapid decline in our liquidity resulting from our below-plan sales and earnings performance in the fourth quarter, the evaporation of the surety bond market, an erosion of supplier confidence, intense competition, unsuccessful sales and marketing initiatives, the continuing recession, and recent capital market volatility, Kmart and 37 of its U.S. subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the Court, on January 22, 2002." 13
The company has no long-term debt because it just filed Bankruptcy and eliminated it through court action. This does not construe a positive financial position.
The Cash Flow statement is perhaps the most condemning in all of the Annual Report. It shows a cleat loss in operating cash from $633 million in 1999 to a loss of -$2,587 million in 2001.14 Cash and Cash Equivalents went up over the three years examined.15 This could be to due to the liquidation of assets and not a true…