Reading Financial Reports for Dummies (14 page)

Part II

Checking Out

the Big Show:

Annual Reports

In this part . . .

You can’t analyze a financial report until you under-

stand all its pieces. In this part, I help you put

together the puzzle of financial reporting. I delve into the key financial statements — the balance sheet, income

statement, and statement of cash flows. I also explore the other parts of an annual report, particularly how to read the fine print in the notes to the financial statements. In addition, I discuss what makes up consolidated financial statements.

Chapter 5

Exploring the Anatomy

of an Annual Report

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 just put out a plain-vanilla, black-and-white version without pictures. But the major components of an annual report are standard, though the order in which companies present them may vary.

When you see a fat, glossy annual report from a company, you can be certain that you’ll find a lot of fluff in it and probably a lot of spin about all the good things that the company accomplished. No matter how fancy or plain the annual report is, as a careful reader, you need to focus on four key parts, listed in order:

✓

Auditors’ report:
A statement by the auditors regarding the findings of their audit of the company’s books.

✓

Financial statements:
These include the balance sheet, income statement, and the statement of cash flows.

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Part II: Checking Out the Big Show: Annual Reports

✓

Notes to the financial statements:
The notes give additional information about the data in the financial statements.

✓

Management’s discussion and analysis:
Management gives its perspective regarding the company’s results.

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.

Everything but the Numbers

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 some areas of management concern. You just need to be a detective: Read between the lines, and read the fine print.

Debunking the letter to shareholders

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.

Don’t put too much stock in this letter, no matter how appealing it looks and how exciting its message is. Very few CEOs actually write the letter to shareholders; the company’s public relations department usually carefully designs the letter to highlight the positive aspects of the company’s year. Negative results, when mentioned at all, are typically hidden in the middle of a paragraph somewhere in the middle of the letter.

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 what the company’s major prospects are.

Don’t let these letters fool you. They
will
focus on the positive news and try to minimize the bad news. Do read the company’s optimistic view, but don’t depend on this letter to make a decision about whether you should invest in the company. You can find more definitive information in other parts of the report that can help you make investment decisions.

Chapter 5: Exploring the Anatomy of an Annual Report
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Translating the language of letters to shareholders

Maintaining a long and proud tradition, let-

✓ Sometimes, letters to shareholders gloss

ters to shareholders present companies in

over mistakes by using a phrase like “cor-

the best possible light using a positive spin to

rective actions are being taken.”
Look for

hide whatever trouble may lie under the sur-

details about the cause and plan for cor-

face. A careless reader may feel reassured

rective actions in the notes to the financial

by the everything’s-hunky-dory tone, but a few

statements or management’s discussion

often-used niceties may indicate that things

and analysis sections.

aren’t what they seem and can tip off careful

✓ If you come across the term “difficulties,”

readers.

look for details about the difficulties high-

✓ “Challenging” is frequently used when a

lighted in the management’s discussion

company is facing significant difficulties

and analysis or notes to the financial state-

selling its product or service.

ments.

✓ “Restructuring” means something isn’t The best place to find full details on these working. Be sure to find out what that issues is in the notes to the financial statements something is and how much the company

or the management’s discussion and analysis.

is spending to fix the problem.

For more on these sections, go to “Getting the

skinny from management” and “Reading the

notes,” later in this chapter.

Making sense of the corporate message

After the letter to shareholders but before the juicy information, you usually find more rah-rah text in the form of a summary about 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 you may enjoy the pictures, don’t count on the info printed around them to help you make any decisions about the company. Even if a company doesn’t use pretty color pictures, this section usually includes bold graphics and lots of headlines that focus on the successes. Don’t expect to find any warning signs in this image-setting section.

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 will present its key divisions or units, what the top products are within these 64
Part II: Checking Out the Big Show: Annual Reports
divisions, and 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.

Meeting the people in charge

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 the place 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, that may be a good sign that you should walk away from the investment.

Finding basic shareholder information

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 for analyzing 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.

Getting the skinny from management

The management’s discussion and analysis (MD&A) 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 as well as what went wrong.

Read the MD&A section carefully. It has a lot of the meat-and-potatoes information that gives you details about how the company’s doing.

Chapter 5: Exploring the Anatomy of an Annual Report
65

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, including

✓

Revenue recognition:
In a retail store, recognizing revenue can be a relatively straightforward process: A customer buys a product off the shelves, and the revenue is
recognized —
that is, recorded in the company’s books. But things aren’t that cut-and-dried in many complex corporate deals. For example, in the computer and hardware industry, revenue recognition can be complex because purchase contracts frequently include multiple parts such as software, hardware, services, and training. When the revenue is actually recognized for each of these parts can vary, depending on the terms of a contract.

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.

✓

Restructuring charges:
When a company restructures a portion of itself — which can include shutting down factories, disbanding a major division, or enacting other major changes related to how the company operates — management discusses the impact this had on the company (or may have in the future). Costs for employee severance, facility shutdowns, and other expenses related to restructuring are explained in this portion of the report.

✓

Impairments to assets:
The SEC expects companies to report any losses to assets in a timely manner. If an asset is damaged, destroyed, or for any reason loses value, companies must report that loss to shareholders. Look for information about the loss of value to assets in the MD&A.

Also look for information about the depreciation or amortization of these assets (see Chapter 4 for more details on depreciation and amortization).

✓

Pension plans:
Accounting for pension plans includes many assumptions, such as the amount of interest or other gains the company expects to make on the assets held in its pension plans and the expenses 66
Part II: Checking Out the Big Show: Annual Reports
the company anticipates paying out when employees retire. If the company has a pension plan for its employees, you should find discussion about how the company finances this plan and whether it expects to have difficulty meeting its plan’s requirements.

✓

Environmental and product liabilities:
All companies face some liability for products that fail to operate as expected or products that could cause damage to an individual or property. In some industries — such as oil, gas, and chemicals — an error can cause considerable environmental damage. You’ve probably heard stories about a chemical spill destroying a local stream or drinking water supply, or an oil spill wiping out an area’s entire ecological system. In the MD&A section, the company must acknowledge the liabilities it faces and the way it prepares financially for the possibility of taking a loss after the liability is paid.

The company must estimate its potential losses and disclose the amount of money it has set aside or the insurance it has to protect against such losses.

✓

Stock-based compensation:
In order to attract and keep top executives, many companies offer
stock incentives
(such as shares of stock as bonuses) as part of an employee compensation package. This part of the annual report must mention details of any stock-based compensation. Many recent scandals have included disclosures of unusually lavish stock-based compensation programs for top executives. Keep a watchful eye (or ear) out for discussion of bonuses or other employee compensation that involves giving employees shares of stock or selling employees’

shares of stock below the market value.

✓

Allowance for doubtful accounts:
Any company that offers credit to customers will encounter some nonpayers in the group. Management must discuss what it allows for loss on accounts that aren’t paid and whether this allowance increased or decreased from the previous year.