investing

How to Read an Annual Report

Focusing on the highlights can tip you off to important trends.

Reading a company’s annual report isn’t like breezing through the latest best-seller. But the information in a Form 10-K, the annual report that public U.S. companies must file with the Securities and Exchange Commission, can steer you toward winning stocks and away from losing ones. To find a firm’s latest 10-K, check the investor relations section of the company’s website or search the SEC’s Edgar database (www.sec.gov/edgar.shtml). The trick is not to read the entire tome, just the parts that matter most. Look for the following sections:

Business. A report starts with an overview of the company. It will tell you what the company does, how it makes money, who its competitors are and where it stands in its industry. It can be a window into company culture. Alphabet’s overview begins, “Google is not a conventional company. We do not intend to become one.”

Risk factors. The company must describe any issue that could adversely affect the business. Some are obvious: A recession could hurt sales volume, for example. Look for unusual ones, such as a single product or customer accounting for a lopsided share of sales. In its 2018 10-K, Spirit Aerosystems Holdings said 56% of revenues came from selling components to Boeing. Since Boeing halted 737 Max production, Spirit stock is off more than 30%.

Selected financial data. This table of key performance data—total revenue and net profit, among other figures—in each of the past five years shows the firm’s sales and earnings trends over time. If the company’s financials have increased steadily, and the management team is still in place, it’s a sign that the firm may deliver similar results in the years ahead. Of course, other trends are important, too. Revenue and income at Gilead Sciences have declined for most of the past five years, a signal to investigate why.

Management’s discussion and analysis. This will highlight business results over the past year compared with the previous one. The writing can be dry. Tables, if the section has any, can be informative. Gilead’s MD&A, for instance, includes a table of revenue in 2018 and 2019 for each of its drugs. Turns out sales are shrinking for one of its top-selling drugs, the liver treatment Harvoni.

Financial statements. The auditor’s report is a declaration from an accounting firm that the 10-K “fairly” presents the company’s current financial position. “Critical Audit Matters” can point to potential problems. Boeing’s 10-K notes that the estimate of liabilities related to the 737 Max’s grounding require a high degree of “auditor’s judgment” to assess. In other words, the estimate is far from certain.

The income statement is a report of sales, expenses and profits in each of the past three years. Look for a rising trend. Big swings in revenue or net income, however, may require digging deeper. Focus, too, on net earnings rather than earnings per share, in part because share buybacks, which cut the number of outstanding shares, can skew earnings per share. Net income rose 10.7% at Domino’s in 2019 year-over-year, but earnings per share jumped 13.6% thanks to share buybacks.

The balance sheet is a snapshot of the company’s financial health. It shows the firm’s assets (such as cash and inventory) and liabilities (outstanding debt). Have retained profits—the earnings a company pours back into its business—risen steadily? Look for little or no long-term debt on the balance sheet. Good companies generate enough profit per year to cover their long-term debt obligation within three to five years.

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