Understanding the Basics of Annual Reports

At the age of 25, I decided to leave a job that felt unfulfilling. I didn't want to follow the typical trajectory of business ownership, working tirelessly until retirement or becoming an overwhelmed entrepreneur constantly seeking the next acquisition funded by mounting debt. My goal was simple: to escape my dire financial situation.

One day, for my birthday, my brother-in-law gifted me two investing books: "One Up on Wall Street" by Peter Lynch and "The Intelligent Investor" by Benjamin Graham. The latter was confusing to me, leading me to abandon it quickly, while I found myself engrossed in the former. However, I was overly optimistic, thinking I could easily become a value investor after reading just one book. Fortunately, my first investment opportunity fell through when the company was delisted.

That experience taught me the importance of learning from the legendary Warren Buffett to become proficient at reading annual reports. Three key books sparked my interest: "The Warren Buffett Way," "The Essays of Warren Buffett," and, of course, "The Intelligent Investor."

My journey is summarized in the following lessons that Buffett imparted through his writings, as well as insights from those he influenced.

1. Establish a Checklist of Metrics

Just as you wouldn't start a vehicle without fuel, you shouldn't dive into an annual report without a clear focus. A good feedback loop is essential in this process. If you lack direction or find yourself reading aimlessly, frustration will soon set in.

Did you know that the average human attention span is roughly 8 seconds? If you apply this to reading annual reports, it emphasizes the need to stay focused on what you're searching for right from the start.

When I examine an annual report, my first step is to review the income statement, balance sheet, and cash flow statement. I look for key metrics such as:

• Revenue
• EBIT
• Depreciation and Amortization
• Current Assets
• Total Assets
• Current Liabilities
• Borrowings
• Equity
• Payments for Plant, Property, and Equipment
• Payments for Intangible Assets
• Business Acquisitions
• Dividend
• Capital Raising
• Outstanding Shares

While this is an extensive list, these metrics allow me to gauge the company's profitability and management effectiveness. I make it a habit to log these figures in an Excel spreadsheet, which keeps me engaged in the process.

You may have your own set of metrics to track, but if you’re looking for a starting point, consider focusing on revenue and EBIT for operating profit margin, borrowings and equity for the debt-to-equity ratio, and calculating free cash flow using EBIT plus depreciation and amortization minus payments for capital expenditures.

2. Analyze the CEO and Chairman’s Letter

I typically perform a quick online search to grasp what a company does in a nutshell, but the CEO and Chairman’s letter provides a deeper understanding of the company's operations. Companies are often more complex than they appear at first glance.

According to "The Handbook of Top Management Teams," the CEO letter is critical because it:

• Offers insight into past and future events
• Justifies actions and decisions
• Aims to create a positive impression

While I recognize the importance of this letter, I approach it with a degree of skepticism, as these letters are ultimately marketing documents. For me, the primary purpose is to elucidate the numbers in the financial statements. For instance, I seek clarity on why a company made a specific acquisition or what its strategic objectives are.

Reading several years' worth of these letters can help you determine whether a management team has maintained a consistent strategy or changed direction erratically.

An excerpt from Warren Buffett's 2021 letter to Berkshire Hathaway shareholders illustrates this point well: he emphasizes that Berkshire's strategy is not limited to a specific asset class, but rather focuses on investing in companies that demonstrate economic resilience and are led by exceptional CEOs.

3. Delve into the Director’s Report, Management Discussions, and Footnotes

Once you've absorbed the previous sections, it's time to explore the director's report, management discussions, and footnotes. These sections are vital for informed decision-making, providing the rationale behind specific actions taken in a given year.

Warren Buffett warns against companies with convoluted footnotes. What does this mean? If you find depreciation and amortization linked with impairment, it may indicate questionable accounting practices.

Why should you be concerned? Impairment is a one-time write-off but can be reversed later, complicating future estimates. Additionally, it may obscure whether certain assets have experienced accelerated depreciation.

I approach these sections like an investigative journalist, seeking to understand the reasons behind acquisitions and how they were financed—whether through capital raising, borrowings, or both. If I find myself losing interest while reading the footnotes, it signals either my lack of understanding of the company or that it may not be a sound investment.

The key takeaway is to correlate the directors’ statements with the metrics you gathered earlier. Any inconsistencies could be red flags.

Conclusions: My Path to Reading Annual Reports in 30 Minutes

Achieving the ability to read annual reports in just 30 minutes didn't happen overnight—it required extensive trial and error. Over the past five years, I've struggled to grasp accounting terminology and comprehend the mindset of CEOs. It involved a lot of additional reading to differentiate between truth and marketing spin in the CEO letters.

Once you identify what you're searching for, these reports become significantly easier to navigate. You're essentially filtering out the noise to uncover the truth, and let me tell you, there’s a lot of fluff in annual reports.

While I haven't struck it rich yet, I'm content knowing I can identify companies that are likely to fail and steer clear of them.

If you found this article helpful, consider joining Medium. You'll gain access to a wealth of articles from talented writers. Sign up using my link below, and I’ll receive a small commission.

Subscribe to DDIntel Here.

This first video, "Warren Buffett: What You Should Look For In Annual Reports," offers essential insights into what to prioritize when examining annual reports.

The second video, "Warren Buffett & Charlie Munger - How To Read Annual Reports," provides valuable tips from two of the most successful investors of our time.