How to Read an Annual Report
The 6-Step Framework from Aswath Damodaran

Annual reports provide crucial insights into a company's financial health, strategic direction, and operational performance. Below is a structured approach to analyzing an annual report effectively.

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1. Confirm the Timing and Currency
Key Questions:

• What period is covered?
• What currency are they reporting in?

Explanation:
- Companies operate on different fiscal years. Some may follow a calendar year (Jan-Dec), while others may have fiscal years that end in March, June, or September.
- Currency matters when analyzing multinational firms. A report in USD, EUR, or JPY can impact financial comparisons due to exchange rate fluctuations.

Example:
- Apple Inc. reports its fiscal year ending in September.
- A European company reporting in EUR may have different financial implications if analyzed in USD due to exchange rate volatility.

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2. Map the Business Mix
Key Questions:

• In which segment does the company operate?
• What does the geographic breakdown look like?

Explanation:
- Large companies often have multiple business segments (e.g., technology, consumer goods, industrials).
- A company's revenue can come from different geographical regions, affecting growth potential and risk exposure.

Example:
- Amazon operates in multiple segments: AWS (Cloud Computing), E-commerce, Advertising.
- Coca-Cola generates revenue globally but faces currency risks and regional market conditions.

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3. Find the Base Inputs for Valuation

From the Balance Sheet:

• How much debt does the company have?
• Does the company have more current assets than liabilities?
• Does the company have a lot of goodwill on its balance sheet?

Explanation:
- High debt can indicate financial risk but also leverage for growth.
- Current assets vs. liabilities determine short-term liquidity.
- Goodwill represents intangible assets, like brand value from acquisitions.

Example:
- Tesla has significant debt due to capital-intensive operations.
- Google's balance sheet shows substantial goodwill from acquiring companies like YouTube.

From the Income Statement:

• Are revenues steadily increasing over time?
• Does the company need a lot of COGS (Cost of Goods Sold) to sell its products?
• How much revenue is translated into net income?

Explanation:
- Revenue growth is a key indicator of business expansion.
- High COGS means lower gross margins, affecting profitability.
- Net income percentage shows efficiency in converting sales into profit.

Example:
- Apple has high margins due to premium pricing, whereas Walmart operates on low margins but high volume.

From the Cash Flow Statement:

• Are most earnings translated into operating cash flow?
• Does the company have a positive free cash flow? (Operating Cash Flow – CAPEX)
• Did the company increase its cash position last year?

Explanation:
- Positive operating cash flow means strong business fundamentals.
- Free cash flow indicates whether the company can fund growth without external financing.
- A growing cash position improves financial flexibility.

Example:
- Microsoft generates massive free cash flow, allowing for acquisitions and dividends.
- Startups may have negative free cash flow as they reinvest in growth.

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4. Keep Digging in the Footnotes

Key Questions:

• Does the company use a lot of SBCs (Stock-Based Compensation)?
• When does the company's debt mature?

Explanation:
- Stock-Based Compensation (SBC) dilutes existing shareholders if issued excessively.
- Debt maturity affects financial obligations—short-term debt can pose liquidity risks.

Example:
- Meta (Facebook) uses high SBC for employee incentives, affecting earnings per share.
- Companies with large debt maturities in a recession face refinancing risks.

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5. Confirm the Units

Key Questions:

• How many shares outstanding does the company have?
• Does the company have preferred shares?
• Are acquisitions paid with stocks?

Explanation:
- Total shares outstanding determine market capitalization.
- Preferred shares have different rights compared to common shares.
- Stock-based acquisitions affect shareholder value.

Example:
- Tesla's stock-based acquisition of SolarCity impacted its balance sheet.
- Berkshire Hathaway avoids issuing shares, preferring cash acquisitions.

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6. Corporate Governance

Key Questions:

• Do insiders get special privileges?
• Does management have a lot of skin in the game?

Explanation:
- Strong governance ensures shareholder interests are protected.
- Insider ownership aligns management's incentives with investors.

Example:
- Warren Buffett holds a significant stake in Berkshire Hathaway, aligning his interests with shareholders.
- WeWork's collapse partly resulted from poor governance and insider privileges.

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Final Thoughts
Understanding an annual report is essential for making informed investment decisions. By following this structured approach, investors can assess financial health, growth potential, and risks before committing capital.