How to read the annual report effectively

The company’s annual report is the most important way for potential investors to understand the company’s financial status. The company’s annual report is also a marketing tool designed to attract investors. The company will try to present itself in the best way without violating any Securities and Exchange Commission (SEC) regulations.

Key points

  • The annual report is an important marketing tool for investors launched by the company, including illustrations, letters from the chairman or CEO, and financial overviews.
  • These reports are similar to 10-K reports filed with the U.S. Securities and Exchange Commission (SEC), but 10-K reports are longer and more “black and white”.
  • When analyzing the annual report, first read item 1, then items 6 and 7.
  • Potential investors should also consider any risk factors related to the company, including litigation and customer concentration.

Unfortunately, although many investors read annual reports, they fail to read them effectively. In other words, although the annual report will not deceive or reflect false information about the business, investors should always read them with suspicion. Learn how to read the actual situation of the company from line to line.

Annual report and 10-K filing

Usually, the company will submit annual reports and 10-K reports to the SEC. The annual report is a shorter version, usually with illustrations, glossy paper, a letter from the chairman or CEO, and a financial overview. 10-K is a longer and more thorough “black and white” document that the company needs to submit to the SEC.

Companies can start by combining the annual report and 10-K with the annual report into one document to provide an overview of the annual results. Sometimes companies will submit 10-K as their annual report because this document is mandatory for every listed company. If the company does submit two reports, the annual report should be checked before 10-K submission.

How to read the annual report effectively

Components of the annual report

If investors are interested in investing in listed companies, they should always read the 10-K file. The report first provides a detailed description of the business, followed by a summary and figures of risk factors, any legal issues.

Generally, the most important components of the annual 10-K filing include:

  • Item 1: Business (description of the company’s business conditions)
  • Item 1A: Risk factors
  • Item 3: Legal procedures
  • Item 6: Selected financial data
  • Item 7: Management’s discussion and analysis of financial status

Where to start looking

There is an effective way to process annual 10-K reports. First read item 1, which is the business description. Item 1 explains the company’s business, who the customers are, and the main industries in which the company operates.

Next, items 6 and 7 explain financial data.Potential investors should evaluate the company’s performance over a period of time. In addition, the financial statements should indicate whether the balance sheet has become stronger or weaker over time.

The cash flow statement should show whether the company is a producer or a user of cash. The company may report negative cash flow while reporting net income. Compare the income statement and the cash flow statement for any red flags.

For example, stable cash flow indicates that the company is healthy and thriving, while large fluctuations in cash flow may indicate that the company is facing difficulties. A large amount of cash on hand may indicate that more accounts are being settled than work received.

Looking for unusual risk factors

Potential investors should also consider any risk factors related to the company. One of the risk factors is the legal action that the company may face. Litigation activities should be disclosed in the company information in the section entitled “Legal Litigation”. There are regulations in the United States that require companies to report any lawsuits, especially if it affects revenue.

Risk factors are submitted to the US Securities and Exchange Commission, where company reports may include statements such as “Our industry is highly fragmented with many competitors” or “Our stock prices may experience fluctuations for a period of time.”

Although these are important risks to consider, they are common and should not significantly reduce the desirability of the business. For example, the abnormal risk factor that needs more attention is whether a large part of the company’s revenue comes from only one or two customers.

In addition, the legal litigation section will disclose any major litigation affecting the company.Although legal issues should be assessed, they may not be as serious as they seem. For a company with a market value of $1 billion, a $10 million pending lawsuit is usually an inevitable part of doing business.

For example, Pfizer, one of the world’s largest pharmaceutical companies, could potentially exceed hundreds of millions of dollars in pending patent litigation and drug liability claims. But this is the same for any large pharmaceutical company, and Pfizer is a drop in the bucket. As of the end of December 2018, Pfizer has nearly $19 billion in cash and short-term investments on its balance sheet.

Focus on what you know

There are different ways to interpret financial information. Read the annual report in a way that suits you, but learn to focus on the most important aspects of the company’s 10-K filing.

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