How to Read an Annual Report
An annual report is a document that publically traded companies are required to make available to shareholders by order of the U.S. Securities and Exchange Commission, or SEC. Annual reports are a critical resource for the casual investor looking to conduct preliminary investment research. In the post-Sarbanes-Oxley world of corporate America, the ability to winnow out the truth from hyperbole contained between the covers of an annual report is a crucial skill for any investment-minded indvidual.
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Instructions
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To get a hard copy of an annual report you can visit a company's website and contact its investor relations group. Usually you'll have to leave a message with your name and address and the company will then mail it to you free of charge. To get a copy immediately, most company's allow you to download a copy directly from its website.
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Once you have the annual report, the first thing you should do is flip toward the back of it report and locate the section titled "Report of Independent Registered Public Accounting Firm." If the annual report does not contain this section, throw it away and avoid investing in the company. A reputable accounting firm is necessary for a publically traded company as it helps prevent Enron-type investment debacles.
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Next, make sure the section titled "Report of Independent Registered Public Accounting Firm" is signed by one of the "big four" firms. Those firms are Pricewaterhouse Coopers; KPMG; Ernst & Young; and Deloitte & Touche. The association of any of these firms with a given annual report should reassure the reader that proper accounting practices have been followed in the preparation of the report.
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Now that you've established that the annual report was compiled using Generally Accepted Accounting Principles, or GAAP, -- the de facto bible of accounting rules -- you start reading it. Perhaps visit the "Letter to Shareholders," which typically provides a good contextual overview of the company's past, present and future.
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Next, it helps to take a peek at the "Notes of Consolidated Financial Statements" where a lot of company's details are placed. Here you'll find information about critical partnerships, competitive risks and pending lawsuits. All are critical factors to consider for the average investor.
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At this point, it's usually a good idea to review the section titled "Management's Discussion and Analysis." This is where a lot of company's place their spin, puffery and other syrupy content to position the previous year in as positive a light at possible. There's good information here, but read it with a dash of skepticism.
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Lastly, look at the "Consolidated Statement of Financials." This is where the actual numbers reside and are broken down into three main parts. The first is balance sheet: A static snapshot in time of the company's financial health. Keep it mind that this document has changed since published in the annual report. The second is cash flow: This portion shows the money flowing in and out of the company; it's just like your checking account, a negative flow is bad. The third is profit and loss: This is a critical section that shows whether or not the company makes more than it spends; bottom line, a company without a profit won't be in business very long.
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Tips & Warnings
This article is a very general, cursory introduction to the basic components of an annual report; it is not to be construed as financial advice. Please consult a brokerage professional or financial advisor before investing any money.
