An annual report exists to communicate the views and expectations of management as well as the financial and operating position of the company, to a diverse audience of shareholders, regulators, potential investors, analysts and other key stakeholders. Annual reports are the best open source of information about a business. Public companies are obliged to file their annual reports on Form 10-K files with the Securities and Exchange Commission. However, annual reports are not just the preserve of publicly listed companies. Private companies and not-for-profits, large and small, are also obliged to prepare annual reports.
We will discuss three key sections of the annual report before discussing broader principles of writing annual reports.
Letter to the Shareholders
A key constituency for the annual report is that of shareholders and potential investors. The letter to the shareholders stands alongside its financial statements, as the most important parts of the annual report, for both shareholders and potential investors.
The letter to the shareholders reveals a lot about a company’s chairman and/or chief executive officer (CEO). Some chairman hide the truth or muddy it, others talk down to their shareholders, and others seem to have been written in a letter-writing factory. The best letters reveal insights about the business so that readers can understand the company they are invested in or plan on investing in. The best letters recognise that shareholders are entitled to a frank discussion of the business, the views of the company’s CEO, and the present and future prospects of the business.
The best letter writer around is Warren Buffett. His letters to the shareholders of Berkshire Hathaway are the gold standard that you should aim for.
The shareholder letters exist as a tool that you can use to attract high-quality shareholders. These are shareholders who will hold stock in your company for a long period of time and who will hold it as a large position within their portfolio. High densities of high-quality shareholders in a business are directly correlated with superior corporate performance. According to Warren Buffett’s 1983 letter, high-quality shareholders can be “attracted and maintained” by consistently communicating the “business and ownership philosophy” of a business and its management, with no conflicting messages. The letter is a tool to demonstrate the policies and vision of the company and attract high-quality shareholders who will have a deep understanding of the company’s operations, expectations and attitudes. It is also a tool to ward off those shareholders the business feels will not understand its operations, expectations and attitudes.
The best letters are not just candid advertisements for high-quality shareholders, they also have emphasise long-term strategic thinking, and illuminate principles that high-quality shareholders focus on: strategic competitive advantage, corporation mission and capital allocation.
It’s important to build a narrative arc over many years in order to transmit a consistent message. One letter is not enough. You may write one great shareholder letter, but in terms of attracting and keeping high-quality shareholders, it’s important to do the business every single year.
General Corporate Information
The business profile section of the annual report communicates what the business is about, and includes the mission statement and vision of the company, details of the directors, registered and corporate offices, company officers, the products or services that are the key drivers of revenue, the investor and company profile and the risk factors of the company as viewed by management.
Management Discussion and Analysis
It’s possible to argue that the business profile is boiler-plate stuff; just copy and paste. The MD&A is not boiler-plate stuff. It gives the report’s audience an overview of the operating and financial results of the business over the last three years, discussing, along the way, such metrics as return on invested capital, profit margins, economic profits, revenue and profits. If your business has recently launched a new product or service, or there are materially important shifts in marketing, sales, or other aspects of the business, this is where to discuss that.
The MD&A is also used to discuss labor issues, capital allocation decisions and any other information that management believes is crucial for the report’s stakeholders to know.
Financial Statements
As we said when discussing the shareholder letters, the shareholder letters and the financial statements are the most important sections for most investors, present and future. It is an exposition of the financial activities and results of the business over the last financial year. Investors can use the financial statements to assess the investability of the company. The balance sheet or “statement of financial position”, income statement, statement of changes in equity, and cash flow statement are the financial statements that are reported in this section of the annual report.
These financial statements show the financial health of the company, whether it is profitable or not, the amount of retained earnings the company has, among other things.
Alongside the financial statements, market share price data and dividend policy have to be detailed within this section.
Other important sections of the annual report are the:
- Director’s Report
- Corporate governance information
- Auditor’s report
- Unaudited information
- Notes to the financial statements
- Accounting policies
- Other features
Principles of Writing the Annual Report
The same principles that govern the writing of a good shareholder’s letter, govern the writing of the rest of the annual report. Candor is the most important quality that an annual report must have. This is not just a question of avoiding lying, but also a question of making it easier for stakeholders to see the truth of a business. Honesty is the bare minimum of an annual report. The real difficulty is preparing the annual report in a way that makes it easy to understand. The language must be as simple as possible and the reporting done in ways that show stakeholders the financial and operating health of the business without them having to perform mental gymnastics to unearth what’s really going on. Earnings distortion is one way in which many businesses have materially distorted their earnings so that it is increasingly harder to find out what a business’ true profitability is. Your job is to make things easy for your stakeholders, not hard. For more information on annual reports, follow this link.