How to Read an Annual Report

Annual reports come in all shapes and sizes. Some are like glossy brochures with all of the important information presented as a company would market to a customer. While others are often described as “10k wraps,” where the no frills presentation might include an attractive cover around a standard 10k filing.

 

In any case, if you want to get to know a company, one of the best places to start is by close inspection of the company’s annual report.

 

You can often find a PDF version for the public company that interests you on the Investor Relations section of their website. If it’s not available there, chances are likely you will be able to request one on the same site. While most annual reports are readily available electronically, you can still find a few in old-fashioned paper and ink at your local library.  One of the nice things about the hard copy of the annual report is that you can literally get a ‘feel’ for how the company likes to present itself to its most important stakeholders.

 

Where to Begin

 

Go to the rear of the report and look for information on the CPA firm that audited the report in front of you. This will tell you if the filing meets generally accepted accounting principles. While this is commonly assumed, we always advise clients to assume nothing when seeking to learn more about a potential investment.

 

Next, take the time to read the footnotes, which are usually in the back of the report as well. That’s where a lot of the most important information resides. Look for explanations of why earnings are up or down, and any forward-looking statements that provide hope or serve as words of caution.

 

Letter to Shareholders

 

Now, go back towards the front of the report and the Letter to Shareholders. This is sometimes called “Letter from the Chairman,” “Letter from the CEO,” or “Letter from Leadership.” Regardless, this is where the top people at the company fulfill their obligations to be transparent and accountable to shareholders.

 

The key things to look for include: the tone of the letter, whether it is upbeat and positive, or cautionary; hard data in the form of revenue growth or declines, earnings per share patterns of growth or decline, and of course, their explanation as to why; information on significant expenditures, losses, cost incursions and investments. The goal when you read the Letter to Shareholders is to get a sense of how company leadership feels about its prospects going forward, and what its plans are to fulfill that potential, or minimize the impact of adverse events and market conditions.

 

As you read this letter, you want to assess how they describe new, growing and mature lines of business and their prospects for the future, and any insights on leadership’s vision for the future for each business and operating unit. Pay special attention to any mention of discontinued product lines, and operations and assets that have been sold or shuttered.

 

Crunch the Numbers

 

Once you’ve gotten this far, it’s time to get into the financial data.

 

The balance sheet is a good starting point. Keep in mind, the balance sheet for any company is just a glimpse of a single point in time for the company. Always know circumstances could have changed since the balance sheet in front of you was published.

 

When you look at the balance sheet, on the left will be a breakdown of company assets, all that the company owns.  “Current assets” are considered assets that can be readily sold and converted into cash.

 

On the right side of the balance sheet is a breakdown of company liabilities, what the company owes.  “Current liabilities” are debts that are due within one year. These debts are paid out of current assets. So, if current liabilities outnumber current assets, that’s a red flag.

 

When current assets outnumber current liabilities, the difference is considered “working capital,” the money the company will use to continue operating in the normal course.  If working capital declines, that could be a warning sign.

 

As you review the balance sheet, pay attention to long-term debt. Rising debt may be a factor of the rising costs of doing business, inflation, or even a hallmark of a rapidly growing company. But as you look at that number, make sure the firm has enough revenue growth to offset the rising debt.

 

Once you’ve studied the balance sheet, it’s time to look at the income statement. This reveals how much money the company made over the past year. At the bottom of the income statement, you’ll find the number for “earnings per share.”

 

This is the calculation that takes all of the revenue and expenses into account and factors them into the impact on each share of stock. Earnings per share (EPS) shows operational growth or decline on a per share basis.

 

One thing to keep in mind when you look at EPS is to determine how the company was able to achieve that. Was it due to rapid growth and high profit margins for goods and services? Or, did the company have to sell business units or operations to save enough money to make that EPS number look better?

 

Look for Patterns

 

Another key data point on the income statement is net sales.  This will tell you whether sales are going up more rapidly than the year before. Are net sales flat or declining?

 

If you have your calculator nearby, do this. Go to the balance sheet. Divide long-term liabilities by shareholder equity. This is the “debt-to-equity ratio.”

 

If this ratio is high, it means the company is borrowing more money to sustain operations or spur growth.

 

Once you’ve done all of this, it’s a good idea to do the same for the company’s annual reports for at least the two years prior. This will give you a better perspective on which direction the company is headed.

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