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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How to Read the Narrative Summary of an Annual Report
The narrative summary provides a glimpse into how the company views its own prospects and also gives some insight into the company’s management and strategies. All narrative summaries of annual reports contain four parts:
- Letter to shareholders
- Management bios and compensation data
- Management‘s discussion and analysis (MD&A)
- Auditors’ statement
When reading the narrative summary, keep in mind that the company is using it in large part to try to present itself in the best possible light, even if its annual financial results were weak. Read between the lines, with skepticism.
Letter to Shareholders
All annual reports begin with a message that’s ostensibly from the company’s top executives but more likely written by the company’s public relations department. This letter to shareholders is typically designed to highlight the positive aspects of the company’s year but should also address negative results. Though you should read this letter to get a sense of the company’s current overall message, never rely on it when determining whether to buy a company’s stock.
Management Bios and Compensation Data
Following the letter to shareholders, the annual report typically contains sections that provide biographical and compensation information about the company’s management team—the group of top executives who run the company.
- Management bios: Information about the educational and business background of each management team member. The bios can help you assess whether the company’s executives are appropriately qualified. If you’re thinking of investing in a software company, for example, you want executives with strong background in the software business, not the pet care business.
- Compensation data: Specifics about salary, stock, and other compensation awarded to the management team. This data can help you assess how fairly the company pays its executives. For instance, if recent financial results are weak, the company shouldn’t award executives exorbitant compensation packages.
If a company’s management strikes you as underqualified or overcompensated relative to management at other, similar companies, you may want to avoid the company’s stock.
Management’s Discussion and Analysis
The management’s discussion and analysis, often
referred to as the MD&A, is the portion of the annual report in which the company’s management expresses its views on the company’s past year of performance and its future prospects. Read the MD&A closely to get a sense of how closely management’s views align with the company’s
actual financial results contained in the balance sheet, income statement, and cash flow statement.
Overall Contents of the MD&A
The MD&A covers four aspects of a company’s business:
- Liquidity: The company’s cash position and ability to cover its expenses on a short-term basis
- Capital resources: The company’s debts and its plans for using debt, such as expansion, acquisitions, and other major capital expenses
- Results of operations: A summary of financial results, including earnings, profits, and taxes
- Market trends: A review of external trends and events in the marketplace, such as weather or energy prices, that may impact the company’s performance
Specific Disclosures in the MD&A
The MD&A contains many specific data points, called disclosures, that can help you get a sense of the company’s financial standing. The specific disclosures you should read most closely are:
- Revenue recognition: Specifies when a company books revenue for a sale, as opposed to when it actually receives revenue for a sale. You should be wary of companies whose revenue recognition policies allow them to book revenue far in advance of actually receiving the revenue: these policies can create the illusion that a company generates much more revenue than it ever actually receives.
- Allowance for doubtful accounts: The company’s expected losses as a result of unpaid accounts receivable. The losses that result from doubtful accounts can reduce or erase a company’s earnings. A notable increase in doubtful accounts over several quarters can signal a problem with the company’s accounts receivable strategy or a general breakdown in the industry’s liquidity.
- Environmental and product liabilities: The company’s risk of being sued or held responsible for paying financial claims made by other organizations or individuals. Companies with a high degree of potential liability, such as chemical transporters or cigarette manufacturers, can see their earnings diminished or erased by litigation fees and judgments.
- Restructuring charges: The company’s disclosure of costs it expects to incur as a result of restructuring, such as shutting factories or relocating parts of the business. These charges can be recurring or confined to one event. One-time charges are less worrisome than recurring charges, though either type can significantly cut into earnings.
- Stock-based compensation: Specific details of stock-based compensation packages awarded to employees. In general, stock-based compensation should reflect the company’s performance. Be wary of companies offering stock-based compensation that seems excessive, especially if company performance has recently been lackluster.
- Pension plans: Companies with employee pension plans (company-paid employee retirement plans) must disclose how they plan to meet the plan’s financial obligations. Be especially wary of very large corporations, as they may have vast pension plan obligations that can threaten earnings.
Auditors’ Statement
The SEC requires companies to pay third-party auditors to verify the reliability and accuracy of financial reports. The auditors create a final assessment, called an auditors’ statement, that usually appears just before or after the financial statements contained in the annual report.
What Auditors Do
Auditors don’t check every single transaction a company makes. Instead, they perform a battery of tests that provide reasonable assurance against material misstatements—errors that can significantly impact a company’s financial position. These tests provide some protection against blatant fraud but should not be considered foolproof.
Contents of the Auditors’ Statement
An auditors’ statement typically contains an introductory paragraph, a scope paragraph, and an opinion paragraph.
- Introductory paragraph: Basic information regarding the audit and financial data it covers, such as the time period the audit covers and the names of the auditors. This paragraph is meant to limit the auditors’ liability by stating that the audit is merely an opinion about the financial data and that the company’s management is responsible for the contents of the financial reports.
- Scope paragraph: A description of the standard set of guidelines for financial accounting, called the Generally Accepted Accounting Principles (GAAP), that the auditors followed to conduct the audit. The paragraph states the rules accountants must follow in recording and summarizing transactions and in preparing financial reports. GAAP standards stipulate that the main goal of the audit is to ensure that the financial report is free of material misstatements.
- Opinion paragraph: The auditors’ conclusions based on the company’s financial reports. If the auditors found no major problems, they’ll say so in the opinion paragraph. An auditors’ statement that uncovers no major problems is called an unqualified auditors’ statement or a standard auditors’ opinion. An auditors’ statement that does uncover major problems is called a qualified auditors’ statement. In such cases, the auditors will use the opinion paragraph to specify the problems they uncovered.
Qualified Auditors’ Opinions
Auditors issue qualified opinions for many reasons. Some are minor and technical in nature; others may indicate major trouble, such as impending bankruptcy. Among the most serious reasons for issuing qualified opinions are:
- Going-concern issues: Auditors issue going-concern qualifications when they have substantial doubt that a company will be able to fund its operations, pay its debts, and remain a going concern—i.e., stay in business. Problems that might lead to this qualification include staffing issues, disputes with suppliers, ongoing losses without the prospect of near-term profitability, and so on.
- Business uncertainties: Some uncertainties in the company’s future could lead to substantial losses, which could in turn prevent the company from remaining a going concern. These can include a possible merger that seems likely to fall through or a major deal with a shady supplier. If an uncertainty merits inclusion in an auditors’ opinion, it’s likely a major threat to the company’s future.
- Questionable accounting practices: When significant differences arise between the way auditors and company management handle the accounting of a major item, such as a sizeable business deal, the auditors will mention the discrepancy in their statement. This qualification can signal unscrupulous management behavior and may be a major red flag.
Auditors may also issue qualified opinions if they’re unable to obtain the information or resources they need in order to issue an unqualified opinion. For example, if the company withholds information from the auditors, the auditors will issue a qualified opinion even if the available financial data is verifiable and accurate.
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