Contents
Financial Report Basics
How to Read the Narrative Summary of an Annual Report
How to Read a Balance Sheet
How to Read an Income Statement
How to Read a Cash Flow Statement
How to Assess Profitability
How to Assess Liquidity
How to Assess Solvency
Summary of Formulas in this Guide
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- Navigate through the sections of an annual report
- Calculate basic ratios to measure profitability, liquidity, and solvency
- Make better, more informed investment decisions
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Financial Report Basics
Financial reports, or financial statements, are documents that summarize a company’s financial performance. All publicly traded U.S. companies that have more than 500 investors and $10 million in net assets, or that are listed on a major national stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ, are required by law to issue financial statements on both a quarterly and
annual basis. This regulation is enforced by the Securities and Exchange Commission (SEC), the U.S. government agency that regulates the investment industry.
Financial reports are meant to create transparency and accountability by making companies’ financial results visible to investors and the market as a whole. The reports are standardized, meaning that the annual and quarterly
reports from various companies contain comparable (though not necessarily the same) financial information.
How Investors Use Financial Reports
Reading a financial report is the only way for most investors to get a good picture of a company’s performance and financial situation. Learning to read and analyze financial reports can help you understand a company’s financial performance in detail and, in turn, make more informed investment decisions. By reading and analyzing financial reports, you can begin to invest based on a company’s fundamentals, or financial statistics—an essential step toward becoming a confident, successful stock investor.
Annual Reports (10-Ks)
An annual report (in SEC lingo, a 10-K) covers a public company’s performance during the previous fiscal year. Private companies don’t file 10-Ks. The report contains two basic parts.
Narrative Summary
The narrative summary is a written synopsis that gives investors some insight into the company’s vision and strategies. It includes the following components:
- Letter to shareholders
- Management bios and compensation data
- Management’s discussion and analysis (MD&A)
- Auditors’ statement
Financial Statements
The annual report also contains three financial statements that provide hard data on the company’s financial performance over the previous year.
- Balance sheet: A snapshot of the company’s financial condition at a specific point in time, including assets (cash, items owned by the company, and money owed to the company); liabilities (debts and financial obligations); and equity (assets minus liabilities).
- Income statement: A breakdown of the company’s revenue (income) and expenses (costs) over a specific period of time. The income statement shows whether the company has earnings, also known as profits or net income. Earnings are the cash that remains after all expenses have been taken into account.
- Cash flow statement: A detailed list of all cash inflows (money coming in) that a company receives from its ongoing operations and external investment sources, as well as all cash outflows (money going out) that pay for business activities and investments.
Notes
Every financial statement includes a set of accompanying footnotes in small print at the end of the financial statements section. These notes, also known as footnotes, serve as annotations to the statements themselves and often include the juiciest, most revealing bits of information in the entire annual report. For example, if a company recently purchased a new private jet for its executives, that minor detail (which could cost tens of millions of dollars) would likely be stipulated in the notes and nowhere else. Companies also often bury their financial problems, such as the cause of a drop in sales or a spike in debt, in the notes.
The “Financial Highlights” Section
Along with their actual financial statements, companies often include a user-friendly summary of their financial data. Typically referred to as financial highlights, this section of the annual report is neither required nor formally regulated. As a result, the financial highlights are not always presented in accordance to accounting rules. Therefore, you should never trust the financial highlights‘ accuracy. Refer to the actual financial statements instead.
Quarterly Reports (10-Qs)
A quarterly report (in SEC lingo, a 10-Q) is similar to an
annual report, with two important differences:
- Timeframe: Quarterly reports cover only the three most recent months of a company’s performance. They’re issued three times per year (the fourth-quarter report is included in the annual report). So if it’s June and you’re reading an annual report that was published in January, be sure also to review the more recent financial data contained in the latest quarterly report.
- Mostly just financials: Quarterly reports don’t contain as much narrative commentary as annual reports. They may have a brief introduction but otherwise contain just the financial statements.
The Best Sources for Financial Data
Most publicly traded companies publish their quarterly and annual reports online for free. Reports are typically available in the following locations:
- Company website: Look for links to the investor relations section of the website.
- SEC website: www.sec.gov/edgar.shtml
- Yahoo! Finance: finance.yahoo.com
You can often get a paper copy of the annual report by calling the company directly and requesting one from the investor relations department.
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