Reading Annual Reports

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If you are at all interested in investing in stocks, it's vital that you get to know your way around the 10-K annual report that companies file each year with the Securities Exchange Commission (SEC). An annual report is a document that describes in detail the business operations of a company, including management's analysis of the past year as compared to other years and the outlook of the company, as well as financial statements.

The 10-K must be filed in a timely manner and include certain pieces of information. Failure to comply with these requirements can result in delisting from the exchange where the company's stock is traded.

In recent years, annual reports have become easier to read, although studies indicate they are still very difficult for the average investor to understand. The SEC is trying to improve their ease of use but it continues to be a sore point between financial regulators and the public companies themselves.

As an individual investor, here are some things you need to be aware of as you read the annual report and 10-K:

  • There are generally nine parts to an annual report. The most important sections are: the letter from the CEO, the management discussion and analysis, the financial statements for the past year and the description of the company's products and services.
  • Understand a company's financial statements, which include the income statement, balance sheet statement and cash flow from operations statement. You'll get a definite picture of its overall financial health.
  • The income statement reveals how profitable a company has been in the past 12 months. Then compare that number to previous years. You should see a trend.
  • The balance sheet shows the financial solvency of a company. Healthy statements have minimal long-term debt compared to shareholder equity, positive working capital (current assets minus current liabilities), and sales growing faster than inventory and accounts payable.
  • Cash flow from operations shows whether a company is bringing in cash faster than it is spending it. This is a critical factor for any successful business.
  • Check to see that the auditors, CEO and CFO have all signed off on the accuracy of the financial statements of the company.
  • Don't get too excited about the pretty pictures included in the report. They are marketing pieces to promote the company.
  • You should read and understand the footnotes at the end of the report. This is where you find the real meat. When you look at the fine print, many investments that appear sound are no longer so.

Investing is difficult enough without doing the homework necessary to be successful. If you truly want to invest in stocks you need to read not only the 10-K, but also the 10-Q (the four quarterly reports filed each year), the 14A proxy statement (matters to be voted on at the annual shareholders meeting), and the 8K (disclosure of significant events). If you do this with every company you plan to invest in, you are far more likely to make an objective decision.

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