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This is a series of articles describing how to quickly understand the key aspects of the annual report from a company that you have invested in with your hard earned money. This series started with an overview post on November 30, 2010.

4. DSO

DSO stands for Days Sales Outstanding. Not all companies will report DSO but if they do, you can usually find it by searching for ‘DSO’, ‘Days Sales’, or ‘Receivables’ in your reader or browser.

In nearly every case, you just want to make sure that this number doesn’t get dramatically larger than it was previously. DSO that is increasing means that the company’s customers are, on average, taking longer to pay for their purchases. This means that your company’s cash is being tied up paying bills and salaries while the check is in the mail from the customers.

You want your company to constantly be working to shrink the DSO metric. A large and increasing DSO can mean that the company is hiding something bad and it is heading into trouble. You may want to liquidate your holdings if the DSO is going up dramatically and you don’t think it is for a good reason.

In general, it is an excellent combination if revenue (sales) and net profit are going up at 10% and the DSO is decreasing.

Here are the links to all 9 posts of the series:

  1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
  2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
  3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
  4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
  5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
  6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
  7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
  8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
  9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)

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This is a series of articles describing how to quickly understand the key aspects of the annual report from a company that you have invested in with your hard earned money. This series started with an overview post on November 30, 2010.

3. Inventories

Many companies have varying levels of inventory over the course of the year. Since the Annual Report is always at the same time, it is worthwhile to see how this metric changes from year to year.

Once again, we are not overly concerned with the growth or reduction of inventory. We are more concerned with why it changed or didn’t change. In general, the company needs inventory to level out pricing and supply chain issues but inventory tends to tie up cash. Also, in some industries the inventory may have less value over time if it is not turned adequately.

The easiest way to find information about inventory in the Annual Report is to do a search on the term “inventories” using your search capability in your reader or browser. Once you find the table that shows the increase or decrease, there will be a few paragraphs discussing the metrics. Does it make sense to you? Does it cause you any concerns?

As a very general rule of thumb, the inventory level shouldn’t change much from previous years. If it does change, in general it should be going down. If the inventory is going up relative to the growth of the company’s sales, you should make sure that the management team has an excellent reason for this increase. If the inventory decreases more than 5-10% from its historical values, you should make sure the management has a reason for that change as well.

If you don’t like the reason for the change (or lack of change) in the discussion, this may be a signal to you to get this company out of your portfolio. Inventory levels are often a ‘mine canary’ for problems in the operations of the company. You aren’t a large enough stockholder to call the Chairman and have the problem fixed, so your choice is to continue as a stockholder or sell your holdings. Don’t think about it any more than that simple test.

Here are the links to all 9 posts of the series:

  1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
  2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
  3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
  4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
  5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
  6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
  7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
  8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
  9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)

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This is a series of articles describing how to quickly understand the key aspects of the annual report from a company that you have invested in with your hard earned money. This series started with an overview post on November 30, 2010.

2. Free Cash Flow

Many people believe that Free Cash Flow is the most important item in an annual report. After profitability and growth, it certainly bears your attention. Free Cash can be a very important tool for evaluating the appropriate stock price of a company.

To find the Free Cash Flow look for Net Cash Provided by Operating Activities. It is usually easiest to just do a search for the term “Net Cash” (I am assuming that you are reading the Annual Report in HTML format or PDF format).

There are no firm metrics that Net Cash needs to increase a certain percentage from one year to the next. In fact, this is why I don’t measure this metric on this site for my Confident Investor Rating. Cash almost by definition needs to go up and down from one year to the next. While it is usually bad for the cash to go negative, the fact that it doesn’t grow at 10% or some other rate is not exactly a bad thing.

The big thing in this metric on a quick analysis is to understand why it changed and was the change typical of the company in former years. Typically, this analysis is embedded in Item 7 of the Annual Report and you will find several paragraphs discussing the cash from the management of the company immediately following the reporting of the cash. Read that analysis and see if you think the changes are logical and help the company grow at the desired rate.

Here are the links to all 9 posts of the series:

  1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
  2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
  3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
  4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
  5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
  6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
  7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
  8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
  9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)

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This is a series of articles describing how to quickly understand the key aspects of the annual report from a company that you have invested in with your hard earned money. This series started with an overview post on November 30, 2010.

1. Profitability

The most important thing to look at in annual report is the profitability of the company and its change from the previous year. If you have spent any amount of time on this site, you will know that you cannot confidently invest in a company that is not profitable.

We also want to understand the “why” of the changes in profitability. It is not enough to know that the company made more or less money, but why did it change. Was it due to more or better products or was it due to an accounting change or a currency change?

The financial data for the company should be in “Item 6. Selected Financial Data” of the report. The very first line is likely to be a revenue or sales line. Did it go up from last year? Did it go up enough (the goal is at least 10%)? If it didn’t go up enough than this likely to be a problem and you may want to just stop investing in this company. There are plenty of companies that are growing by 10% so you may not want to invest in a company that can’t figure out how to grow their top line fast enough.

Further down the table you will see a Net Income line (or perhaps it will be called Net Revenue). Once again, the big questions are:

  • Did it go up?
  • Did it go up enough from last year? The threshold is still 10% growth!

If the company was able to increase top line revenue adequately but not increase the net revenue, you should be concerned. Perhaps you should look at the costs that were taken from the top line revenue number and deduce what happened.

On the flip side, perhaps you shouldn’t worry about the reason things didn’t work out for this company. It is not your job as a small investor to understand why things are not working to your expectations at your company. You can simply choose to not be an owner of this company if it doesn’t live up to your expectations. Don’t spend your precious time trying to fix the company – that is what the managers that are employed there need to do. As an investor, you need to decide if they are performing the job well and then decide if they deserve your investment dollar.

Here are the links to all 9 posts of the series:

  1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
  2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
  3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
  4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
  5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
  6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
  7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
  8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
  9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)

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For any company that you are invested in, you should understand the annual report. The annual report is the formal financial statement issued yearly by a corporation. The annual report shows assets, liabilities, revenues, expenses and earnings – how the company stood at the close of the business year, how it fared profit-wise during the year, as well as other information of interest to shareholders.

When the report is first published, I suggest that you spend 20 minutes looking at 7 critical items. Once you have insured these 7 items are covered, you can then read the entire report at your leisure over the next few weeks (but definitely don’t wait more than a month to read the report).

In your leisurely reading of the report you can focus on how the company is making money, what are the challenges it is facing, and possible changes in the revenue model. This is primarily covered in Part 1 of the report. The larger the company, the more that is covered in this area so it is important to set aside time to really study this document.

You will also want to study at length the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that is found in Item 7. This is likely quite long and in-depth so take your time over several weeks to really understand this information. You don’t want to rush this but instead you want to spend time reading and understanding this information.

This technique of doing a quick read begs the question:

“What seven items should I concentrate on in the annual report in that first 20 minutes?”

In a series of posts over the next few weeks, I will suggest the various items to investigate. These posts will come out on Tuesday and Thursday on this site.

  1. Profitability
  2. Free Cash Flow
  3. Inventories
  4. DSO
  5. Backlog
  6. Shares outstanding and stock repurchase
  7. Dividends

I hope that this series of posts will be interesting to you and help you be a better investor.

Here are the links to all 9 posts of the series:

  1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
  2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
  3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
  4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
  5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
  6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
  7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
  8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
  9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)