Before you invest in a stock, you should definitely read financial statements. However, before you do that, you will have to learn how to read them correctly.
The very first thing you should notice, of course, is the EPS – earnings per share. Of course, this is the facet of the financial report everybody anticipates and tries to figure out. So, of course, if you are researching a stock, the EPS is probably the best way to start. People commonly refer to the EPS as the bottom line. And they do so for a good reason. It is the facet that represents the profit and loss of a company.
Naturally, the headlines in most media outlets will usually focus on the EPS. And, while it is the most important metric, it is still only one of the components you should focus on. Namely, there are two more crucial components in regards to a financial statement of a company that you have to understand. Namely, the statement of cash flows and the balance sheet.
Of course, reading an online article will not turn you into a pro. However, it will help you understand the information you are getting. So, you can maybe save some money you would otherwise spend on consultants.
So, let’s start off this online lesson about financial statements by taking a look at the 10-K and annual reports.
Preparing for the lesson
As always, if you plan to conduct an investigation, you should first aggregate the data you expect to use. In essence, collect the materials you require to build the basis of your inquiry. However, what information should you be looking for, and where should you check?
Well, for starters, you should always check the 10-K and 10-Q forms as well as the annual report. Usually, all of those documents are easily accessible. Simply go to the investor relations option on the website of the company that you are investigating.
Form 10-K
The company makes this official filing to the SEC. The 10-K will usually have these sections:
* Overview of the company
* Overview of the financial data
* Information about the director and the senior management
* Executive compensations
* Consolidated financial statement that includes reports of an independent accounting company
* Other information
Form 10-Q
This is the “mini-me” version of the previous form. It is a quarterly form that includes financial statements without audits and notes about those financial statements.
Annual Report
The company sends this publication to all of its shareholders. Most companies will also make the annual report available for potential investors. Of course, not every company will make the same annual report. Some put a lot of effort into it, while others just add a few words to their 10-K form. Let’s cover three examples that vary depending on the amount of energy:
Low Effort: For example, Ruth’s Chris Steak House will put next to no effort into their annual report. Most of the time, they will just use their 10-K with a glossy cover.
Medium Effort: Somewhere between the two examples are those that offer a decent annual report, but in the end refer people to their 10-K. As an example, we will use the Duke Energy company. Their annual report offers a business overview and consolidated financial statements. However, they do still rely on their 10-K to do the talking.
High Effort: An example of a company that puts in a lot of effort into their annual report would be Amylin Pharmaceuticals. They hire professionals to design their annual reports and even incorporate a message to their shareholders. They also include the business overview that features (but doesn’t limit itself to) the management of the company, the products they offer, new projects they are starting, and the way they operate. You can also find the report from auditors, consolidated financial statements, and notes for all of those.
A Step by Step Guide on How to Read These
Ok, now we have gone through the reports you should acquire. However, we still haven’t shown you how to address the information you can find in these. So, these are the steps to follow in your investigation.
Step 1 – Find Reports From the Independent Accounts
The first thing you want to find out is if the company’s records and statements are presented in a fair and an appropriate manner. You should also find out if they are in line with the GAAP (Generally Accepted Accounting Principles). That means that you will have to make sure that the company did receive an unqualified report. Companies that receive this report are companies that have no items that could cause a GAAP exception, and the financial conditions of the company don’t indicate any possible issues regarding the company’s existence.
This report will usually open with the general information about which company it concerns, as well as which period of the company’s history the independent auditors are auditing. They will usually go through the consolidated statements of operations, the equity of stockholders, and the cash flow of the company. It is very important for this report to state that the financial statements of the company are fair in their representation of the financial situation of the company in question. The report should also mention any changes that the company went through lately. So, if the company changes the method of accounting for their payments, you will be able to find it in this report.
It is very important to go through this report to find if there are any red flags that should worry you. Make sure to read the entire report to check if any irregularities might be a cause for concern.
Step 2 – Read the CEO’s Letter
A majority of annual reports will include the letter from the chief executive officer of the company. And you would do well to read it. As you probably already know, the CEO is the actual leader of a company. As such, the CEO will be the one that manages the operations of the company and sets the plans for its future. So, you should definitely want to know what the CEO has to say. This letter will usually talk about how the company started, how it is doing right now, and what the plans for the future are.
Since these are personal notes from the CEO, no two letters from the CEO are the same. Some of them will be there to advertise the company as it is and praise its workings. On the other end of the spectrum, you will have CEOs who are very critical of the situation. They will focus on the mistakes that happened in the past, and the changes they are making to avoid those mistakes. They will also tell you what the challenges of the future are. Overall, you should always take the time to read the letter of the CEO.
Step 3 – Read the Overview
Companies don’t always remain the same throughout their history. They usually go through various changes. As always, the demand is the factor that dictates the strategy alongside market conditions in the world. And that goes for every company and every industry out there. You, as an investor, are the one paying for the expansion of the company. So, make sure to read the business overview to see what the future plans are. After all, you want to know what your money is going to do for the company. The overview will also give you the general idea regarding the current products of the company and the position in the competitive nature of the market.
The Conclusion
In the end, you can probably notice that there is a lot of homework you would have to do before you even start analyzing the numbers. So, before you go on with your trading day, choose any company, regardless if you are a stockholder in that company, find their annual report and 10-K forms and try to analyze the data you see there. This way, you can formulate your own opinion about where the company is going instead of relying on various analysts to do it for you.
