The notes to financial statements, frequently referred to as "footnotes"or "financial notes", contain some of the most important information in corporate financial reporting. It is not possible for companies to provide all the necessary details in their financials. The notes, therefore, are used to provide critically important additional disclosure and are considered to be an integral part of financial statements. It is essential for investors to learn how to read and understand the information they provide. For this purpose, there are some basic techniques you can acquire, but reading financial notes is as much an art as a science.
There are a few basic rules that all investors can use when trying to decipher any corporate financial statement. This overview will provide a foundation for understanding these important documents and, as a result, the financial footnotes as well.
Some Rules of Thumb
There are some general rules of thumb that will help you gain a better picture of the world of financial reporting:
Rule No.1: Not all disclosures are created equal.
Disclosures in 10-K filings and corporate annual reports are much more informative than in 10-Qs and corporate quarterly reports. This difference is an out-of-date holdover from the pre-digital age, when companies argued that it was too costly to provide full disclosure every quarter. Even though everything is now digital, regulators still haven't made quarterly updates a requirement, so some important information on key areas such as pension data is not updated each quarter.
Rule No.2: Rules are meant to be bent.
In the beginning, the Securities and Exchange Commission (SEC) made the rules, but shortly thereafter came lawyers, accountants and other high-paid financial engineers who find ways to circumvent the new disclosure and tax laws. Each economic cycle is followed by a new wave of reform, which helps perpetuate this cycle of change.
Rule No.3: Potential rewards require high effort.
If analyzing companies were easy, everybody would do it and there would be nothing to dispute the existence of an efficient market. But it takes hard work to gain a competitive advantage in business and investing. The harder you work, the more you know. The more you know, the more you can avoid the mistakes of the past and make money. (For related reading, see Working Through The Efficient Market Hypothesis.)
Rule No.4: Know the company, industry and the weaknesses of both.
In order to find warning signs, you have to know where to focus your reading. To do this, you need to be aware of the possible areas where trouble could first develop. For example, the auto industry (and any heavily unionized industry) carries more of the type of risk created by underfunded pension plans than a high-tech industry. When evaluating a company in the auto industry, you would want to spend more time analyzing the pension note than the options disclosures (although an auto company may also have "option risk").
To know how to streamline your approach to any particular company's financial notes, you need to do some primary research, which means reading not just one SEC filing or corporate report but several years of a company's financial reporting from cover to cover. This primary research will give you a better feel for how management communicates and how it obfuscates. Don't trust anyone else's summary. Your own experience gained from this preliminary reading will provide you with a perspective that will make it easier to spot the red flags.
Rule No.5: The "bad stuff" is always buried.
Rarely does a company admit its mistakes in headlines and tables or make them easily found in required disclosures. Generally, the red flags are buried in long paragraphs filled with legal boilerplate that may be difficult to read and understand. But the hard work it takes to do some digging does pay off with an insight that is often overlooked, even by the pros.
Enron, despite its many flaws, did provide enough disclosure in its financial notes to make any sane investor worried. Informed investors could therefore have cut their losses by selling at the first sign of trouble. But it was reporters from the Wall Street Journal who made the effort to dig into the notes and find the off balance sheet partnerships and conflicts of interest. The headlines, however, shouldn't have been the first alarm that Enron investors heard. (For more on this, read Cooking The Books 101 and Common Clues Of Financial Statement Manipulation.)
Rule No.6: Consistency is NOT the rule; you need to compare disclosures.
Disclosures change from filing to filing as the result of events or changed assumptions. In other words, you can't read just one disclosure and expect to have the whole story. You need to analyze any changes, which will provide an insight into the quality/credibility of management thinking.
Assumptions used in healthcare cost estimations for example, are usually found in a section about other post-retirement benefits. Start in 1999 and you may see a company whose management assumes that healthcare costs will rise in the mid single-digit range and decline to low single-digits during the next five to seven years.
Now, read the latest 10-K or annual report and you may see that these assumptions, including the assumed steady decline, have not changed even though healthcare costs have actually increased in the 15-20% range and are expected to increase in the low double-digit range in 2004. The company's failure to adjust its assumptions indicates that management is either keeping estimates low to minimize the adverse impact on earnings, is out of touch with reality and/or plans to shift more than half of the increase to the employees. A company that assumes increases in the double-digit range will have more credibility than the company with the single-digit growth assumption.
The Bottom Line
Reading the notes to financial statements is hard work, but you will get better at it the more you do it. Because these skills will help you protect your money, remember to keep them sharp with practice and never to underestimate their value. For more insight, see Footnotes: Start Reading The Fine Print.