A company's annual report is the single most important way for potential investors to understand the financial state of a company. A company annual report is also a marketing tool designed to attract investors, and a company will attempt to present themselves in the best light possible without violating any Securities and Exchange Commission (SEC) regulations. Unfortunately, while many investors read annual reports, they fail to read them effectively. In other words, while annual reports do not deceive or reflect false information about the business, investors should always read them with a sense of skepticism. Learn how to read between the lines and decipher the actual condition of the company.
Annual Report Versus 10-K Filing
Typically, a company will file both an annual report and 10-K report to the SEC. An annual report is the shorter version that often comes with illustrations, glossy pages, a letter from the Chairman or CEO, and an overview of the financials. The 10-K is a longer, more thorough black and white document that a company is required to submit to the SEC.
Companies may merge the annual report and 10-K into one document with the annual report at the beginning to provide an overview of the year's results. Sometimes, a business will file the 10-K as its annual report since that document is mandatory for every public company.
If a company does file both reports, the annual report should be examined before the 10-K filing.
How To Efficiently Read An Annual Report
The Components of an Annual Filing
Investors always read the 10-K filing if you are interested in investing in a public company. The report begins with a detailed description of the business, followed by risk factors, a summary of any legal issues and, finally, the numbers and financial notes.
Often, the most essential components of the annual 10-K filing include:
- Item 1: Business (a description of the company's operation)
- Item 1A: Risk Factors
- Item 3: Legal Proceedings
- Item 6: Selected Financial Data
- Item 7: Management's Discussion and Analysis of the Financial Condition
Where to Start
There is an efficient way to tackle annual 10-K reports. Read Item 1 first, which is the business description. Item 1 explains what the company does, who its customers are, and the primary industry in which it operates.
Next, Items 6 and 7 explain the financial data. A potential investor should assess how the company has performed over a period. Also, the financial statements should indicate whether the balance sheet has become stronger or weaker over time.
The cash flow statement should show whether the business has been a generator of cash or a user of cash. It is possible for firms to report net income while, at the same time, having negative cash flow. Compare the income statement with the cash flow statement for any red flags. For example, steady cash flows are indicative of a healthy and thriving company, whereas large fluctuations in cash flows could signal that a company is experiencing trouble. Large amounts of cash on hand could indicate that more accounts are being settled than work received.
Look for Unusual Risk Factors
Potential investors should also consider any risk factors associated with the company. One risk factor is legal proceedings that the company might be facing. Litigation activities should be disclosed in the company information in a section called Legal Proceedings. The United States has regulations that require companies to report any litigation, especially if it affects income.
Risk factors are filing to the SEC, and the company reports might include statements such as, and "our industry is highly fragmented with many competitors" or "our stock price may experience periods of volatility." While these are important risks to consider, they are common and should not significantly reduce the desirability of the business. Unusual risk factors that require greater attention are, for example, if the company generates a substantial portion of its revenue from just one or two customers.
In addition, the Legal Proceedings section will reveal any significant lawsuits affecting the company. While legal issues should be assessed, they may not be as severe as they seem. For a billion-dollar company, a pending lawsuit for damages of $10 million is often an unavoidable part of doing business.
For example, Pfizer, one of the largest drug companies in the world, may have pending patent lawsuits and drug liability claims that may exceed hundreds of millions of dollars. But that's par for the course for any major pharmaceutical company and a drop in the bucket for Pfizer, which had over $19 billion in cash and short-term investments on the balance sheet at the end of December 2018
Focus on What You Know
There are different ways of interpreting financial information. Read the annual report in a way that works for you, but learn to concentrate on the most important aspects of a company's 10-K filing.