Annual Reports

QUESTION (A):

We have seen a lot of Annual Reports of various companies. This annual report consists of the financial statements, financial highlights, operations during the period, letter to the shareholders, auditor's report, management's discussion and analysis, graphs and narrative information, etc. The annual report shows the analysis of the company's financial position in the market and the operations during that particular period. The annual reports are prepared by the companies so that the investors (like shareholders), financers (like lenders) and operators (like customers, employees, etc) can make decisions about their company. The major financial decisions are made in the areas of investments of the resources, operation of the company using these resources and the financing that funds these resources. Financial Statements are a mode through which decisions are made doing various analyses. These financial statements can be published or distributed to the public through various means, but now-a-days the main or the best source of getting is the company's annual report or the company's websites.

Lately measures have been developed which helps in knowing the financial position as well as the performance of the company in the market. It is very important that the information of the company is properly contextualized to understand it so that the techniques can be implemented feasibly. As mentioned earlier, the Annual Report consist various financial information regarding the company, the user of this information therefore has to encounter with a huge volume of data. But the problem with this huge volume of data is that it is presented in such a way that it becomes hard to deal with it because the data can hardly be contextualized. So unless the data is given in a particular feasible format, it would become difficult to analyse it and therefore will lose its significance. In order to overcome these problems of huge volume of data and the contextualization of that data various approaches have been developed by various people. These approaches can broadly be classified in two categories:

1) Fundamental Analysis, and

2) Technical Analysis.

These are simply the ways of looking at the information relating to a company and its shares.

(Source: Financial Information Analysis, Chapter 7 - Fundamental Analysis, Pg. 188-189)

FUNDAMENTAL ANALYSIS:

Fundamental analysis is used to identify the prices of the securities. It studies balance sheets, income statements, along with macro-economic data to forecast the overall performance of a particular business or an industry as a whole. This analysis helps to understand whether a particular stock is undervalued or overvalued, to estimate company's performance, evaluate its market position with past sales records, earnings, cash flow. This evaluation indirectly reflects on company's success or failure.

(Source: Financial reporting & analysis- Revsine, Collins, Johnson, chap 1, pg 5)

In short fundamental analysis provides dependable and consistent information. They are the test which provides a judgement and comparison. They exploit historical data like dividend rates, profits so that forecast can be made easily for comparing the financial results.

(Source: Mastering Fundamental Analysis, by Michael C. Thomsett, chap 1, pg 3)

(http://books.google.co.uk/books?id=Iy6neIFjO0C&pg=PA2&dq=efficiency+of+fundamental+analysis&cd=8#v=onepage&q=efficiency%20of%20fundamental%20analysis&f=false)

Characteristics of Fundamental analysis:

a) Fundamental analysis provides extra dimension of information.

b) It sometimes analyses a major price move.

c) A knowledgeable investor would adopt a more approach towards that situation where fundamental suggest for a potential of a major price move.

d) A deep understanding of fundamental analysis provides an incentive to stay with the highest profits.

e) The information given by fundamental analysis can be used as a trading tool even by technical analysts.

(Source: Schwager on Futures- Fundamental Analysis by Jack D. Schwager, Part two fundamental analysis, pg 25.)

TECHNICAL ANALYSIS:

“The term ‘Technical', in its application to the stock market, has come to have a very special meaning. It refers to the study of the action of the market itself. Technical analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in ‘The Averages' and then deducing from that pictured history the probable future trend.”

Note: With the advent of computers, many schools of technical analysis have arisen. Number-driven technical analysis attempts to completely objectify the analysis of the markets. The above mentioned definition is the ‘classical technical analysis' and is the embodiment of the work of Edwards and Magee.

(Source: Technical Analysis of Stock Trends, The Technical approach to Trading and Investing, Robert Davis Edwards, John Magee, W.H.C. Bassetti, Pg 4)

The above definition explains us that Technical Analysis is basically research in demand and supply in terms of investments based on past historical data both in price and volume. Technical analysts firmly believe that they can predict the movement of the stocks or market value from equilibrium to equilibrium by using several charts and computer programmes of past stock data, commodity and market movements. With all these they find a trend which they believe will predict the price movements. Chartists are not concerned about the reason affecting such changes. They just want to predict so that they can take advantages at the beginning of the changes whether it be short-term, medium-term or long-term gains.

(Source: http://www.referenceforbusiness.com/encyclopedia/Str-The/Technical-Analysis.html, Author: KathrynSnavely and updated by PaulBolster)

There are mainly three approaches by which technical analysis is done:

a) Moving averages: The moving averages are one of the oldest tools used to analyse technical analysis. It is basically the average price of a security at a given specific time. Specification of the time span is considered while calculating moving averages.
(Source: Technical Analysis from A to Z by Steven B. Achelis, pg 27)

b) Time Element: Much of the information in technical analysis focuses on the changes in the prices over the time.
(Source: Technical Analysis from A to Z by Steven B. Achelis, pg 13)

c) Charts: Charts are prepared based on the historical data on price movements. These charts are used to identify shapes and patterns, such as double top, double bottom, head and shoulder and triple bottom. There are different types of charts like volume bar charts, candle stick charts, semi log verses linear scaling.
(Source: Technical Analysis from A to Z by Steven B. Achelis, pg 7-8)

Technical analysis is, perhaps, the oldest form of security analysis. This analysis was first believed to be occurred in Japan in the 17th century, when they used to plot down the price changes of Rice in the charts and then used to predict the prices according to a trend. In fact, it is still used in Japan to forecast the prices of the stocks in the stock market. This form of analysis was very useful during the period when the financial statements were not available. But it has several disadvantages. It is only profitable for short-term investments. When it comes to long-term investments the past pricing patterns does not necessarily repeat in the future, and since in technical analysis future prices are forecasted by gathering and analysing the past pricing patterns, this won't be possible as future is very uncertain. Secondly, it is a study more of probabilities than the actual-value. Thirdly, the analysis is highly based on person to person. Therefore, each analysis will differ from other even if the analysts are looking at the same pricing pattern history. Another disadvantage of technical analysis is that it is a self-fulfilling prediction, so if sometimes stocks prices are increasing it may just be because people may be purchasing that stock as it must have a prediction of a price increase in future.

(Source: http://www.referenceforbusiness.com/encyclopedia/Str-The/Technical-Analysis.html, Author: KathrynSnavely and updated by PaulBolster)

When analysing Financial Statements the Fundamental Analysis is more useful rather than Technical Analysis. As already mentioned above what do we mean by Fundamental and Technical Analysis, I will further state how Fundamental Analysis is more useful in analysing the Financial Statements.

The investor's first form educated opinions and proper analysis about the company's value and its equity securities and then make their investing decisions based on these opinions and analysis. Investors therefore follow the fundamental analysis approach through which they estimate the value of the securities by assessing the amount, timing and uncertainty of the future cash flows that will accrue to the company issuing the securities. For the purpose of estimation data is taken from the financial statements. These estimations are then discounted for the risk and time value of money. The discounted cash flow is then compared to the company's current stock price and thus allowing the investors to make decisions regarding the stock. Even the liquidation values are calculated from the financial statements by taking the selling value of each individual assets and subtracting debt from it. Ratios are one of the most common used analysis tool used. For example the Price-Earnings ratio is calculated by the investors to know how much they can earn from each price paid to the company and then compare it with other companies in the industry.

Even the creditors use the financial statements of the company to asses if the company is able to meet its debt related financial obligations in the way of interest and principal or asset liquidation. Creditors form opinions on the credit risk of the company by comparing the required principal and interest payments with the current and future cash flows of the company.

Financial advisors also use fundamental analysis for analysing the financial statements in order to provide information to the investors and creditors. Financial advisors include brokers, portfolio managers, security analysts, etc. They can gather process and evaluate the financial information more economically and accurately than individual investors and creditors because they have that specialized skill and knowledge and they also have access to the particular information and resources provided by the organisation. And therefore they play a crucial role in the decision making of the investors and creditors.

(Source: Financial Reporting and Analysis by Revision.Collins.Johnson, chap 1, pg 12)

The analysis of a company's fundamentals gets deep into its financials and they do not really concentrate on the daily movement of their shares price. The researchers of the equity also carry out the fundamental analysis so as to calculate the intrinsic value of a company's stock.

A Company's Fundamentals constitute various components:

a) Revenues: Revenues are the total amount of money that company receives through their sales. It is known as one of the important barometers for the growth of company as it indicates demand and supply.

b) Cash Flows: Cash Flows indicate the working capital and the liquidity position of the company. It mainly shows the performance of the business so it must be paid attention.

c) Balance Sheet: It reflects the assets and liabilities of the company. A Company's balance sheet must be carefully analyzed as they show the debts and payments where the company is entitled to. This is done with the help of fundamental analysis.

(Source: Where is Fundamentals Analysis? Dated April 16th 2006, by Joel Arberman) (http://www.articlesbase.com/find-articles.php?q=fundamental+analysis+and+company's+statement+)

Independent auditors also carefully examine the financial statements before the conduct of an audit of those statements. They try to understand the management reporting rules which enable them to analyse the important areas where they feel financial errors are likely to occur. They choose the appropriate audit procedures so that they are able to detect the major flaws.

(Source: Financial Reporting and Analysis by Revision.Collins.Johnson, chap 1, pg 13)

So above we have seen how the Fundamental Analysis of Financial Statements can be used by different users in order to make several decisions regarding the company. Therefore financial statements are very important for the company and most importantly ‘Fundamental Analysis' is the best way to analyse the financial statements of the company so that the participants of the company can make their decisions effectively.

QUESTION (B):

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