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7 Clues for Investors to Look for Within Annual Reports

You don’t have to be Warren Buffett to know what makes a company tick.

Way back when, if you owned stock in a company, you’d often find a glossy annual report in your mailbox. Nowadays, all you may receive is a letter telling you where to download the report on the company’s Web site. And truth be told, annual reports are being supplanted by the Form 10-K, the annual filing required by the Securities and Exchange Commission. Don’t be put off by the form’s intimidating appearance. We’ve highlighted some key sections—and what to focus on in each.

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1. Business. The first part of the 10-K provides a thorough look at what the firm does or makes, its divisions, and where in the world its products are made and sold. It also gives info on key customers and competitors, and where the company stands in its industry. You may even learn an interesting fact or two—for example, that there really were a Mr. Procter and a Mr. Gamble, and that they founded P&G in 1837.

2. Risk factors. Listed in order of importance, these are the factors that may adversely affect the company’s business. Much of this section, found just after the “Business” description, may elicit a big duh, such as P&G’s disclosure that “our businesses face cost fluctuations and pressures that could affect our business results.” But read carefully and you may ferret out less-obvious risks, such as a disproportionate share of sales coming from a single product or customer.

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3. Management’s discussion and analysis. In Part II of the 10-K, the company reports and analyzes its performance over the past year compared with the previous year’s results.

4. Income statement. This is a basic report of sales, expenses and profits. Ideally, you want to see a trend of rising sales and earnings. A 10-K typically shows three years of results, as well as a five-year summary in the section called “Selected Financial Data.” Focus on the trend in net earnings rather than earnings per share, in part because share buybacks, which cut the number of outstanding shares, can skew earnings per share and thus camouflage a drop in overall profits.

5. Balance sheet. This is a snapshot of the company’s assets (such as cash and inventory) and its liabilities (such as outstanding debt). Zero in on how much long-term debt the firm carries and whether retained profits, the earnings a company reinvests in its business, have grown in each of the past three years. Great companies have little or no long-term debt on their balance sheets—or they generate enough profit annually to pay off that debt within three to five years.

6. Notes to financial statements. To some people, the 10-K notes matter as much as the statements. That’s because Note 1 describes the accounting methods used to prepare the financial statements. If a company has made a change to its methodology from the previous year, any results from prior years, as well as the current year, that are stated in the current 10-K will be adjusted to reflect that change.

7. Auditor’s report. Look for this key sentence: “In our opinion, the financial statements present fairly...the financial position of the company.” That means the company has honestly described its finances over the past year to the best knowledge of the accounting firm that is auditing the 10-K.

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This item was originally published in the September 2014 issue of Kiplinger's Personal Finance.

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