CASE STUDY: READING THE ANNUAL REPORT: TEN ISSUES TO CONSIDER

The ASIC website publishes a range of information designed to allow amateur investors to avoid the pitfalls of making illinformed decisions when investing. These tips include advice on the best way to use a company's annual report to make an assessment of its financial performance. They include the ten issues detailed in the following. There are lots of matters you can check in the annual report. Here are the ten issues you should consider, grouped into three areas: operational and strategic activities of the company: the year's highlights financial results future strategic directions and performance: looking ahead to next year.

The year's highlights . . . 1. Are the activities reported by the chairman and managing director the same as the activities the company said it was going to do either in its prospectus or last annual report? Any prospectus the company issued may have included information about markets the directors were aiming to penetrate and the products the company planned to produce. The company may also have made statements in the annual report or announcements to the market about new or different activities it plans on pursuing. Ask: Is the company doing the same things shareholders expected it to be doing, for example, was it going to build websites whereas now it is selling computer hardware? If it was going to sell products, is it selling the same products? If there has been a change in the activities, this may mean the company's prospects are significantly different. There may be different cost structures associated with the different activities and they may require different amounts of development or capital expenditure. There may be differences in the amount and timing of revenue for the company.

2. Is the current business strategy the same as that described in the prospectus or last annual report? If it has changed, how will it affect the performance of your investment? Business strategy can be described in various ways future directions, strategic objectives, business plans, corporate goals and vision statements. What are the ultimate goals of the company? Are the company's activities moving towards these goals? For example, did the company say it would develop ecommerce software applications for the banking industry, and now it is considering biotechnology products for the medical industry?

3. If strategic acquisitions were made during the year, how did they add value to the company? Many companies make strategic acquisitions in other companies. For example, they purchase a substantial shareholding in another company. This company may be complementary because it sells key products to your company or it may provide access to additional markets, new technologies or new products. Such investments may or may not generate a direct dividend/revenue stream for the company. Where investments like these have been made, how will these acquisitions help the longterm future of the company? Will the investment assist the company in achieving its short- and longterm objectives? For example, if the company's strategy is to establish a significant market presence in Australia, how does acquiring a business in Brazil help achieve this objective?

4. Has a tangible result been achieved from any money spent on research and development activities, such as developing high technology products or software applications? Companies may spend significant resources on areas described as research and development, product development and intellectual property development. These activities generally aim, among other things, to develop new products, improve existing products and help a company stand out in the market. Such expenditure will not always produce immediate results, but it is important for you to understand the size and purpose of the expenditure and any results that have been achieved. A tangible result is something like the first sale of a software application or starting production of a high technology product or entering into a technology licence agreement for another business to use the technology developed by the company. Financial results . . .

5. Did the company receive any revenue from its business activities? If it didn't, did the directors explain why not? In last year's annual report or a recent prospectus, the company may have expected to generate a certain amount of revenue in the coming year. These expectations may have depended on the types of revenue, some of which may be more sustainable over the longer term, and the amount of that revenue. When reviewing the financial results, look at the actual revenue of the company and where it came from against these expectations. For example, did it come from selling software products or licensing technology rights to another business?

6. Did the company make a profit or a loss? If it was a loss, did the directors explain why? Many companies during their 'startup' phase do not make a profit. If this is the case, the directors may indicate in the annual report when they expect the company will make a profit. If this is not discussed in the report, ask the directors at the AGM. You should also consider the factors that will or may affect whether this profit forecast is achieved.

7. How did the company fund its activities during the year? Did the company generate its own cashflow from its business activities or did it merely rely on funds from other sources such as funds raised from shareholders, debt financing and asset sales? In reviewing the statement of cash flows in the financial report, consider the source of the company's cash for the year. For example, has the company only used the money raised from the issue of shares or has it borrowed additional funds through loans or by issuing convertible notes (these are debt securities than can be converted to shares at a later stage)? If the company has issued more shares during the year, have these diluted existing investors' shareholdings? Be aware that the statement of cash flows normally has three sections: operating activities, investment activities and financial activities. Looking ahead to next year . . .

8. Is the company going to change its activities or business strategy for next year? Companies operating in a competitive environment have opportunities for the future, and risks or hurdles that must be overcome to achieve success. Think about the key factors that will affect future performance and how the company plans to address these making the most of the opportunities and minimising the risks.

9. How long can the company last at its current 'cashburn' rate? If it looks like it might run out of cash during next year, what is the company proposing to do about this? 'Cashburn rate' usually refers to the rate at which the company is using its cash reserves. Where the company is not yet generating cash from its operations, see where cash is being spent and the rate at which it is being spent. Many high technology companies lodge cash flow statements with the ASX at the end of each quarter. You may want to ask for a copy of the company's last couple of cash flow statements. Where a company is not yet producing revenue but is still using cash to fund its operations, you should assess whether the company will have enough cash on hand until revenue begins to be generated. If it won't, how will the company meet its requirements. Will it try to raise more funds or will it borrow the money?

10. Is the company going to make a profit next year? How? You should get an idea of what the directors expect for the coming year. If a product is still in the development phase, the directors may think that the company will continue to run at a loss. However, if the company is beginning to develop markets for its product, expectations may be more positive. You should also distinguish between possible developments, customers and contracts, and those prospects that are more certain.

QUESTIONS 1 Obtain a copy of an annual report issued by a listed company.

2 Follow the suggestions of the corporate regulator and analyse the annual report: (a) Examine the figures in the financial statements to get an overall impression of the financial performance of the company. (b) Note which figures you think are important to an understanding of the financial performance of the company you have chosen. (c) Read what management has to say about these figures in the front half of the report. (d) Return to the financial report and examine the figures again, taking into account what management has said in the front half. Has your assessment changed in any way? How?

3 Write a short assessment of the company as a potential investment.