A company's annual report is the single most important way for it to convey itself to potential investors. As such, it should come as no surprise that an annual report serves to present the company in the best light possible without violating any Securities and Exchange Commission (SEC) regulations. Unfortunately, many investors read annual reports but fail to read them effectively. In other words, while annual reports are clearly prepared without any intent to deceive or reflect dishonesty about the business, investors should always read them with a sense of skepticism. In other words, learn how to read between the lines and decipher the actual condition of the company.
Annual Report Vs. 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 pictures, nice glossy color pages, a letter from the Chairman or CEO and an overview of the financials. The 10-K is the 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, then use the annual report as a first look at a business before tackling the 10-K filing.
How To Efficiently Read An Annual Report
The Components of an Annual Filing
If you are interested in investing in a public company you can not avoid examining and reading the 10-K filing. The report begins with a detailed description of the business, followed by risk factors, a rundown of any legal issues, and, finally, the numbers and financial notes.
Often, the most essential components of the annual 10-K filing are the following items:
- 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 Financial Condition
How to Start
There's a way to tackle annual 10-K reports that is efficient and effective. Start by reading Item 1, which is the business description. This will allow you to understand what the company does, who its customers are, and the industry it operates in.
Next, you should jump to Items 6 and 7 and examine the financial data. How has the company performed over a period of years? Has the balance sheet become stronger or weaker over time? (Learn how to analyze the balance sheet in Breaking Down The Balance Sheet.)
Look over the cash flow statement and see if the business has been a generator of cash or a user of cash. It's possible for businesses 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.
Look for Unusual Risk Factors
Afterward reviewing the financial information, it's time to determine if any information is lurking beneath the surface. Go back and read the risk factors section and the legal proceedings section, if any legal matters exist.
Because this is a filing to the SEC, the risk factors will be detailed. You may find statements such as, and "our industry is highly fragmented with lots of competitors" or "our stock price may experience periods of volatility." While these are important risks to consider, they're pretty common and should not significantly reduce the desirability of the business. Instead, focus on any unusual risk factors, such as if the company generates a substantial portion of its revenue from one or two customers.
In addition, the Legal Proceedings section will alert you if any significant lawsuits are in the works. Again, don't ignore any legal liabilities, but if you're looking at a company worth billions of dollars, and it has a pending lawsuit against it for damages of $10 million, it may not be as serious as it may seem.
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 part of the normal course of business for any major pharmaceutical company, and a drop in the bucket for Pfizer when you see that the company has over $50 billion in cash and short-term investments on the balance sheet.
Focus on What You Know
We all have different ways of deciphering and storing information. Feel free to 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. By doing so, you can avoid wasting unnecessary time.