How To Read an Annual Report

By Nora Dunn on 21 March 2008 (Updated 26 April 2010) 5 comments
Photo: redjar

Once a year you may receive these bulky packages in the mail for each of the stocks or mutual funds in your portfolio. You'd like to take interest in them, really. You know it would enlighten you as to the inner workings of your investments and turn you into that much more a savvy investor. You want to read them. You open them up, with the intention of scouring them for divine investment wisdom.

 

And after about five minutes, with eyes glazed over, your annual report finds its way to the place where oh so many annual reports find themselves: the recycle bin.

 

You are not alone! Here are the basics of reading an annual report, so you can get the most out of it.

 

Once a year you may receive these bulky packages in the mail for each of the stocks or mutual funds in your portfolio. You'd like to take interest in them, really. You know it would enlighten you as to the inner workings of your investments and turn you into that much more a savvy investor. You want to read them. You open them up, with the intention of scouring them for divine investment wisdom.

 

And after about five minutes, with eyes glazed over, your annual report finds its way to the place where oh so many annual reports find themselves: the recycle bin.

 

You are not alone! Here are the basics of reading an annual report, so you can get the most out of it.

 

An annual report can be comprised of many different components, including the following:

  • Financial Statements
  • Chairman’s Address
  • Corporate Address
  • Listing of Board of Directors
  • Stockholder information
  • Auditor’s report
  • Management messages

 

There are many other miscellaneous pieces of information contained in an annual report, which vary from company to company. But the bulk of information of interest to investors is usually contained in the Financial Statements. This article will address these statements in detail.

 

There are three components to a company’s financial statements as part of their annual report:

  • Cash Flow Statement
  • Balance Sheet
  • Income Statement

 

All components compare statistics year over year, showing the past one to three years' stats, in addition to the most recent year's stats. This allows you, the investor, to relatively compare the numbers to see how the company is progressing overall.

You can detect if that company is getting its act together since a recent takeover, how an industry is reacting to certain pressures, and (most importantly) whether or not to keep your money invested (or invest more).

You can see where they are spending their cash, and how it is translating into revenue for the company, and ultimately for the investors. You can also see the source of their incoming cash: whether it takes the form of profits, sale of goods, or new investment money coming in.

 

The three components of an annual report marry nicely to provide a true picture of the solvency and direction of a company.

 

Cash Flow Statement

Just as it sounds, a cash flow statement details all the money flowing in and out of the company.

It contains three main sections:

  • Operations
  • Investing
  • Financing

 

Operations

This will detail the company's earnings, as well as depreciation of assets and inventory changes (increases in inventory use up cash, and reductions provide cash).

 

Investing

Expenses in this category include investing in new supplies, property, equipment, land, and anything that will generally add value to the business. Investments that have been made over the year will show as a negative number (but will ideally increase the value of the business or their ability to turn a profit).

Financing

Positive numbers in this section indicate where the company is getting its money from: selling stocks, bonds, or borrowing from the bank.

Negative numbers show the company buying back stock from holders, paying out dividends, and repaying borrowed cash.

What to look for in the Cash Flow Statement

Ideally you want to see that they can pay for their Investment activities with their Operations activities. Having to use Financing to stay afloat is a losing proposition for an established company and a bad sign.

If the financing number is negative, that’s actually a good thing. It means the company is buying back stock to keep the value high.

 

 

Income Statement (also known as Statement of Earnings or Statement of Operations)

This is the statement that shows the bottom line: profit or loss. It depicts the money coming in from sales, and the expenses associated with making those sales.

 

You’ll generally see a number of subsections in the Income Statement:

  • Sales/Operating Revenue
  • Sales Costs
  • Gross Profit
  • Operating Expenses
  • Operating Income
  • Net Profits (Earnings)

 

Sales/Operating Revenue

Just as it sounds, this section will detail how the company is making money; through sales of goods and provision of services.

Sales Costs

There is always a cost of doing business, which you’ll see outlined here. Only expenses directly related to the sales revenue will be included though; costs to turn raw materials into finished products, salaries of those workers, and overhead of the facility.

You won’t see a number of other expenses that could be construed as contributing to the sale of goods, like marketing and research.

Gross Profit

Subtract Sales Costs from Sales Revenue, and you have your gross profit (or loss).

Operating Expenses

Here come the rest of the expenses not listed in the Sales Costs section.

Operating Income

Subtract the Operating Expenses from the Gross Profit and you have Operating Income.

This is a key number in the report, because it truly gives a picture of their ability to turn a profit with their price points given the costs associated with operating the business.

 

Net Profits (Earnings)

There are still a few key expenses to take in to account, which are detailed in this section. The main expenses include interest payments to bondholders and taxes.

At the bottom of this section you’ll see the magic number: Net Profits/Net Income or Earnings.

 

What to look for in the Income Statement

This statement depicts the company’s true “bottom line” (on the bottom line!) year over year. Obviously you want the number to be positive, and ideally you want it to grow year over year.

If you take the net income and divide into it the number of outstanding shares the company has, you will get Earnings Per Share (EPS), a common valuator investors use to determine the viability of a company. Rarely is this full amount distributed to the investors though; it is often retained to be invested in future business activities (hence the term Retained Earnings).

 

 

Balance Sheet (also known as the Statement of Financial Position)

Similar to a personal balance sheet, you will see Assets and Liabilities itemized.

 

Assets

Within this category you will often see two main sub-categories: Current Assets and Fixed Assets.

Current assets include cash and anything that can relatively easily be converted to cash. Fixed (or non-current) Assets include less liquid assets: property, and depreciable assets like machinery.

Liabilities

Similar to assets, Liabilities can be divided into two categories; Current and Fixed/Non-Current/Long Term. Current liabilities are those that can and need to be paid within the year; long-term are beyond one year.

Among liabilities, you will see money owed to banks, money owed to investors, taxes owing, and other miscellaneous accounts payable items.

Shareholder’s Equity

This is simply expressed as Assets minus Liabilities. It is representative of what the owners (shareholders) own.

 

What to look for in the Balance Sheet

Obviously you would like the bottom line (Shareholder’s Equity) to be a positive number!

But beyond that, some attention should go into what exactly the assets are made up of. If a large part of the assets are in the form of retained earnings from previous years, then the company’s “bottom line” for the year really isn’t as good as it may first appear. (That’s why you cross-reference this report with the Income Statement).

 

Some extra references for your reading pleasure include:

IBM’S Glossary of Terms

Money Chimp’s How to Read an Annual Report

 

 

And if you're still falling asleep before you reach page three of the annual report, consider electing not to receive annual reports. It will save the company on printing and postage fees (which in turn sends more profits to you the investor!), as well as save resources that are otherwise being wasted. It doesn't make you a bad investor; rather it makes you a realistic and environmentally savvy one. Just make sure you get your investment advice from a solid and trusted source if you’re not willing or able to go the distance yourself.

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Guest's picture
Julie

I'm actually taking an Intro Financial Accounting course this semester. I'd considered going into a program to become a C.A., but I don't think I will. On the other hand, I'm finding it very useful to know how to really read the financial statements, what ratios to look for, and how it all gets put together.

One of the things I've realized, though, is that it makes no sense to look at a single financial statement in a vacuum. You've got to also know the numbers (or at least the ratios) for other companies and for the industry, as well as previous years of the company you're studying. Otherwise, you've got nothing to compare the numbers *to*. And numbers without a context aren't really helpful at all.

rstlne's picture
rstlne

For most large corporations, the first half of the annual report (the glossy part with photos) is like a mini magazine showing off the company's products or projects. The meat is in the financials at the back. However, I think the annual report alone is not enough. Serious investors should also take a look at quarterly statements. These days, you can find all those reports on the web.

Guest's picture

If you own stock in a corporation and only look at the annual reports, you're committing investment sin #1. Don't buy something you don't understand. Learn how to break down a cash flow statement and the statement of earnings. Balance sheets are important, just remember they are a moment in time statement. Not a summary.

I concur with comment number one, learn how to compare statements with their closest competition. All the ratios are meaningless without a basis of comparison.

Guest's picture

Great post! I have gotten those in the mail for my 401k and ROTH IRAs and wondered how to read them. I filed them from last year, but now I'll have to go back and look them over! Thanks again!

Guest's picture
Guest

You left out the Statement of Shareholders' Equity.