Checking out a company’s annual report is a must for investors.
The 10-K forms that public companies file with the Securities and Exchange Commission include audited financial statements, which along with other pertinent information, provides an overview of a firm’s financial health. Luckily, Credit Suisse’s accounting and tax research team says “you don’t need to be an accountant laureate” to interpret these dense documents.
In a two-part series, The Financialist will offer practical tips on how to mine a 10-K, based on a recent Credit Suisse note entitled “10-K Checklist.” Click our annotated images below to zoom in.
The Checklist: An Annotated Overview
Part I: This is your introduction to the company. Some elements are self-explanatory, but we’ve flagged the most important questions.
Part II: The Nitty-Gritty. This is a go-to section for most investors, since it contains the financial statements, which we’ll discuss in more detail later.
Part III: Knock, knock. Who’s there? Part 3 gives you a rundown of key figures, as well as a hint about relationships within the company.
Part IV: The Laundry List, so named for the raft of appended documents and information this section contains.
Now, let’s take a deeper dive.
Management Discussion and Analysis
In this section, company executives tell their version of the story, explaining revenue trends, uncertainties and upcoming events. If you still have questions after reading, watch out.
“When you see boilerplate disclosures that don’t provide real answers as to why something happened, that may be a red flag, and you should ask yourself what the company is trying to hide,” Credit Suisse’s note said. “At the very least, it’s poor disclosure, and high-quality companies that want a premium valuation should provide high-quality disclosure.”
Here are some specific things to look for:
Liquidity and Capital Resources: As Credit Suisse’s accounting and tax team notes, “Just because a company looks happily liquid and flush with cash doesn’t mean that it’s readily available as a source of liquidity, especially if it’s parked overseas,” in which case, the company might face a large tax bill to get at their money. Credit Suisse notes that more companies are disclosing where they park their cash, but if they don’t, look out for an SEC comment letter [which] can also sometimes provide further detail.
Other questions to ask: Could planned product releases, pricing changes, rising costs, changes in credit terms or other variables impact future cash flow? Watch for information about the sources and uses of cash, planned expenditures and how they will be funded, and whether the company seems to have enough cash to pay its bills.
Contractual Obligations: There should be a table showing how much money the company owes as a result of contracts it has signed, as well as a payment timeline. Knowing how much companies owe and when payments are due can give you a better picture of the firm’s cash cushion.
Critical Accounting Estimates: Companies reveal here which of their accounting estimates and assumptions would significantly impact the financial statements if they were to change. Ask yourself whether the assumptions seem conservative or aggressive, and in light of that, how changes in these estimates could affect the bottom line. If the company has changed its assumptions, figure out whether the results reflect the new framework or the firm’s actual performance.
Off-balance-sheet activity: You’re looking here for details on contracts, transactions and agreements with customers, lessors, asset purchasers and other people the company does business with. Try to figure out whether the moves make sense to you and if they seem like valid business deals. Decide whether you should factor them into your appraisal of the company.
These figures provide a snapshot of the company’s financial well-being. Compare this statement to the one from the prior year to see if anything specific has changed in the way the information is being presented. Other key points:
Balance sheet: Check if the assets and liabilities seem to be fairly stated and match up to each other. Note how the company finances itself and whether the structure of the balance sheet is overly complicated – and if so, why? Have you accounted for the company’s off-balance-sheet activities into your analysis? Finally, try to determine whether the company has sufficient liquidity, or whether it is sitting on a pile of cash that could be better used elsewhere.
Statement of changes in shareholders’ equity: Don’t blow by this section, which deals with dividends, share repurchases and share issuances. It also has information about accumulated other comprehensive income, such as what the company gained and lost from translating the balance sheets of foreign-owned subsidiaries into the currency the parent company uses, available-for-sale securities, derivatives held as cash flow hedges and changes in pension-funding status. Think about whether and when some of these issues might impact earnings.
Audit opinion: Four words are red flags here: “significant deficiencies” and “material weaknesses.” Changes in auditors should also draw your eye.
Check out Part 2, where we dive into the all-important footnotes and a photo-illustrated guide to some key exhibits.