Chapter 5
In This Chapter
Getting acquainted with the parts of the annual report
Looking at the three most important documents
Summing up the financial information
No doubt the financial statements are the meat of any annual report, but lots of trimmings make up an annual report, and you need to be able to read and understand them. Although companies must follow set rules for how they format the key financial statements, how they present the rest of the report is left to their creativity.
Some companies spend millions of dollars putting on a glossy show with color pictures throughout the report. Others put out a plain-vanilla, black-and-white version without pictures. Still, the major components of an annual report are standard, although the order in which companies present them may vary.
In this chapter, I explain why these four parts of an annual report are so critical. I also define the other parts of an annual report and their purposes.
Most people think of numbers when they hear the words annual report, but any savvy investor can find a lot more useful information in the report than just numbers. Some parts of the report are fluff pieces written for public consumption, but others can give you great insight into the company's prospects, as well as suggest some areas of management concern. You just need to be a detective: Read between the lines, and read the fine print.
What would an annual report be if not an opportunity for the head honchos to tout their company's fabulousness? Near the front of most annual reports, you find a letter to the shareholders from the chief executive officer (CEO) and the chairman of the board; other key executives may have signed their names, too.
In these letters, you usually find information about the key business activities for the year, such as a general statement about the company's financial condition, performance summaries of key divisions or subsidiaries that were the shining stars, and the company's major prospects.
After the letter to shareholders, but before the juicy information, you usually find more rah-rah text in the form of a summary of the company's key achievements throughout the year. Like the president's letter, these pages present more of the type of message the corporation wants to portray, which may or may not give you the true picture. Few companies include much information about negative results in this section. Often chock-full of glossy, colorful images, this section is pure public relations fluff that focuses on the year's top performance highlights.
Although this section is basically advertising, it may give you a good overview of what the company does and the key parts of its operations. The firm generally presents its key divisions or units, highlights the top products within these divisions, and gives a brief summary of the financial results of the top divisions. In addition, you usually find some discussion of market share and position in the market of the company's key products or services.
Want to find out who's running the place? After the corporate message, one or two pages list the members of the board of directors and sometimes a brief bio of each member. You also find a listing of top executives or managers and their responsibilities. If you want to complain to someone at the top, this is where you can find out where to send your letters!
But seriously, reviewing the backgrounds of the company's leaders can help you get an idea of the experience these leaders bring to the company. If they don't impress you, it may be a good sign that you should walk away from the investment.
At the end of the key financial statements, you usually find a statement of shareholders’ equity, which is a summary of changes to shareholders’ equity over the past three years. The key parts of this statement for current-year results are in the equity section of the balance sheet (one of the key financial statements that I talk about in greater detail in Chapter 6).
This information is good to know because you can get an overview of changes to shareholders’ equity over the past three years, but you don't need this information to analyze a company's prospects. When I show you how to analyze results by using information about shareholders’ equity, I use numbers that you can find on the balance sheet.
The management's discussion and analysis (MD&A) section is one of the most important sections of an annual report. The MD&A may not be the most fun section to look at, but in it you find the key discussions about what went smoothly over the year and what went wrong.
The Securities and Exchange Commission (SEC) monitors the MD&A section closely to make sure that companies present all critical information about current operations, capital, and liquidity. Management must also include forward-looking statements about known market and economic trends that may impact the company's liquidity and material events, as well as uncertainties that may cause reported information to not necessarily reflect future operating results or future financial conditions. For example, if a company manufactures its products in a country that's facing political upheaval or labor strife, those conditions may impact the company's ability to continue manufacturing its products at the same low cost. The company must report this information, indicating how this situation may impact its future earning potential.
The SEC pays special attention to a number of key factors that the MD&A is supposed to cover:
When reading financial reports for a particular industry, reviewing how management describes its revenue-recognition process compared to similar companies in the same industry is important.
In the MD&A, managers focus on three key areas: company operations, capital resources, and liquidity.
Management commentary on this topic focuses on the income the company's operations generate and the expenses related to them. To get an idea of how well the company may perform in the future, look for the following:
The MD&A section also discusses these areas:
The manager also comments on key profit results and how they may differ from the previous year's projections.
Also look for cost information related to product manufacturing or purchase. Cost-control problems may mean that future results won't be as good as the current year's, especially if management mentions that the cost of raw materials isn't stable.
Look for statements about interest expenses, major competition, inflation, or other factors that may impact the success of future operations.
A company's capital resources are its assets and its ability to fund its operations for the long term. In addition to a statement that the company is in a strong financial position, you'll find discussions on these topics:
A company's liquidity is its cash position and its ability to pay its bills on a short-term or day-to-day basis. I cover how to analyze liquidity in Chapters 12, 15, and 16.
Management has been required to include a section called “Corporate Responsibility for Financial Reports” or “Management's Responsibility for Financial Reports” since the financial reporting scandals of the late 1990s and early 2000s. When the Sarbanes-Oxley Act of 2002 passed Congress, this guarantee became more critical.
Today the chief executive officer (CEO) and chief financial officer (CFO) must prepare a statement to accompany the audit report to certify that, “based on such officer's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report,” according to Section 302 of the Act.
Executives were asked to provide these letters in the past, but this new requirement must include a certified statement, signed and notarized for public view, indicating that management takes full responsibility and can be held legally accountable for what's in the financial reports.
Executives can now be held personally responsible for their actions and may face up to a five-year prison term, fines, and other disciplinary action. They may also face civil and criminal litigation, and the SEC may bar them from serving as a corporate officer or director.
CEOs and CFOs have responded to this new requirement by looking for ways to shield their money and property from shareholder lawsuits and federal prosecution. The key question not yet answered is whether we will actually see this enforced and whether it will protect investors and the public from the corporate scandals we have seen in the past.
Any publicly traded company must provide financial reports that outside auditors have examined. (I talk more about the audit process in Chapter 18.) You usually find the auditors’ report (a letter from the auditors to the company's board of directors and shareholders) either before the financial information or immediately following it.
To lend credibility to management's assurances, companies call in independent auditors from an outside accounting firm to audit their internal controls and financial statements. Auditors don't check every transaction, so their reports don't give you 100 percent assurance that the financial statements don't include misstatements about the company's assets and liabilities. Auditors don't endorse the company's financial position or give indications about whether the company is a good investment.
Most standard auditors’ reports include these three paragraphs:
When an auditors’ report follows the outline I describe here, it's called a standard auditors’ report. And because no qualifiers (or red flags) limit the auditors’ opinions, it's also an unqualified audit report.
If the auditors find a problem, the report is a nonstandard auditors’ report. In a nonstandard report, auditors must explain their opinions in a qualified audit report — in other words, they qualify their opinions and note problem areas. (I discuss possible problems auditors may encounter later in this section.) A nonstandard auditors’ report and a standard auditors’ report have the same structure; the only difference is that the nonstandard report includes information about the problems the auditors found.
A nonstandard auditors’ report may include paragraphs that discuss problems the auditors found, such as the following:
But whenever a company changes auditors, you need to know why it made the change, and you need to research the issue. You probably won't find the reason for the change in the annual report, so you may have to research the change in news reports or analysts’ reports. Because changing auditors can negatively impact a firm's stock price, companies are usually very careful about doing so. Wall Street typically gets concerned whenever a change of auditors occurs because it can be a sign of a major accounting problem that hasn't surfaced yet.
If the auditors disagree with the company's decision to change accounting methods, they question the change and provide a qualified opinion (which I discuss later in this section) in the nonstandard auditors’ report. If their report indicates a change in accounting policy, be sure to look in the notes portion of the annual report for the full explanation of the change and how it may impact the financial statements. When companies change an accounting policy or method, the change impacts your ability to compare the previous year's results to the current year's.
If a loss is probable and the auditors can estimate it, the financial statements usually reflect this loss, and the auditors give an unqualified opinion. So in reality, the impact of a known loss can be a greater problem than a possible loss with unknown consequences. The company and the auditors have a responsibility to make you aware of the uncertainty so that you can factor it into any decisions you make about your potential dealings with or investment in the company.
Many times the auditor believes that these are matters the public needs to know about but aren't signs of a serious problem. For example, if the company is doing business with another company that has officers involved in both firms, the auditor may note this issue in a special paragraph. The notes to the financial statements explain any specific disclosure in greater detail.
The main course of any annual report is the financial statements. In this part, you find out what the company owns, what the company owes, how much revenue it took in, what expenses it paid out, and how much profit it made or how much it lost. I cover each of the following statements in great detail throughout the book, so I mention them briefly here and indicate in which chapters you can find additional information.
For example, a retail store usually has much better results in the last quarter of the year (from October to December) because of the holiday season than it does in the first quarter (from January to March). Comparing these two quarters doesn't make sense when you're trying to determine how well a business is doing. To judge a retail company's growth prospects, compare the fourth quarter of one year with the fourth quarter of another year. I talk more about income statements in Chapter 7 and tell you how to analyze these statements in Part III.
Knowing that most people won't spend the time to read all the way through the annual report, many companies summarize their numbers in various ways. The two most common ways to summarize are to highlight the financial data presented in the financial statements and to summarize some key information in the notes to the financial statements. But beware: Most summaries highlight the good news and skip over the bad.
The highlights to the financial data summarize the financial results for the year being reported. Typically, this summary is called the financial highlights, but companies can be creative because this section isn't a required part of the report. And because the highlights aren't required, they're not always presented according to GAAP rules, so don't count on their accuracy. You usually find the financial highlights at the front of the annual report, after the letter from the CEO and chairman of the board. Some companies include them inside the annual report's back cover.
The notes to the financial statements is the section where you find any warts on a company's financial record. The notes are a required part of the annual report, and they give you the details behind the numbers presented in the financial statements. Companies like to hide their problems in the notes; in fact, most companies even print this part of the annual report in smaller type.
Most of the details in the notes discuss the impact that the following business aspects may have on the company's future financial health:
If any red flags pop up in a company's annual report, this part is where you can find the financial details and explanations. The auditors’ report probably highlights any potential problems and red flags that you want to search for in the notes. You may also find problems mentioned in the MD&A section, but the notes section probably covers the full explanations for these problems in greater detail.