Each year, public companies release their annual report on Form 10-K. A 10-K report can look super boring, but it reveals the bulk of the information you need to know before investing in a stock.
If you don't have time to read it from cover to cover, you'll want to take a shortcut to some of the most important sections. That way, you can see if you understand the business, need to do more work, or should walk away from the stock.
1. Start with the MD&A
The Management's Discussion and Analysis, or MD&A, is an overview of the company's business. It's prepared by company executives and covers products, strategies and competition. The management team also adds their take on the events of the past year, which usually skews optimistic. Although it has a lot of dense text, the MD&A can usually be understood by someone who does not have accounting experience. It's narrative, not numbers, that describes the state of the business with insights for the future.
Some MD&A filings are famous for giving investors detailed market outlook information. The letters written by Warren Buffett for Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) are legendary for their insight into his investment process.
2. Page back to the risks section
The company's list of risk factors runs before the MD&A, but you might want to read it after tackling the MD&A. That way, you'll have more context to understand whether the risks listed are boilerplate or real.
There are two ways to know if a risk is real. The first is if it is also discussed in the MD&A. The second is if it coincides with current economic news. For example, many companies have something in their risk section about needing to recruit and retain a good workforce. Right now, unemployment is really low, so workforce risks are going up.
3. Read the auditor's report
A good next stop is the Report of the Independent Registered Public Accounting Firm, which often offers a head's up for potential problems. In a public company, management prepares the financial reports, and the accounting firm comes in to check their work. In this report, the auditors describe their concerns. The company management isn't necessarily doing something wrong, but the list from the auditors may point to weaknesses and risks that you have not considered.
Look for information about reliability of the company's accounting system, details about inventory controls, or pending litigation. Cross-check with the risks section to see if any of the information matches. If it does, it could be cause for major concern.
4. Look for consistency
Consider reading further into the financial statements and take a look at the Consolidated Statement of Operations, also known as the Consolidated Income Statement. This shows how much money a company brings in and what it costs to run the business. You might want to take a look at the lines after "net income from operations". Are there a lot of special expenses, restructuring charges, or discontinued operations? If so, you will need to do more work to understand this company and avoid unpleasant surprises like missed earnings or executive office turnover.
These lines may indicate that the company's business changes a lot, either because of market conditions or because of management issues. If you're an investor who prefers more stable, long-term growth, then you'll want to see consistent growth and good expense control.
5. Check out the cash flows
Another good financial statement to look at is the Consolidated Statement of Cash Flows, especially if you are researching a manufacturing or retail business, because the accounting system was designed for them. This is a tricky one, and if you're looking at a financial company, it may be challenging to understand. It connects the numbers on the income statement to the numbers on the balance sheet to show how a company actually spent its money.
Think of it as the difference between a paycheck and a bank statement. Two people may earn the same amount of money but spend it in very different ways.
Take a look at the totals for cash flows from operations, investing, and financing. In the long run, a company has to make money from operations to stay in business, so the number for cash flows from operations should ideally be positive. If it's negative, the company may be in a start-up phase, or it may be struggling to hit its earnings numbers.
Next, look at cash flows from investing. In the long run, it should be negative. After all, it takes money to make money! A business needs to replace old equipment, update outmoded fixtures, and keep its product line current. If cash flow from investing activities is positive, the company may be selling off assets. Cash flow from financing activities may be positive or negative.