Annual Reports, the 10-K, and the 10-Q Filings
Investing Lesson 3 - Analyzing a Balance Sheet
When analyzing a company to calculate what you think it is worth, it is imperative that you get your hands on the company's balance sheet, which typically means locating a copy of the firm's annual report, Form 10-K filing, and/or Form 10-Q filing. Each document serves a different purpose and has a different role in understanding the business. Therefore, in the following paragraphs, I will explain how each one is important and where you can find a copy.
The Annual Report
You may already know about the annual report, this once-a-year publication is a document released by companies several months after the end of their fiscal year. It includes almost everything an investor needs to know about the business. An annual report generally contains pictures of facilities, branch offices, employees, and products, which are normally followed by a letter from the CEO and other senior management. This letter discusses the past as well as the upcoming year. Tucked away in the back of most annual reports is a collection of financial documents, footnotes, charts, and disclosures (all of which you would be wise to read as they can help you uncover a truer picture of the firm).
To get an annual report, most of the time you can go to a company's website and find the Investor Relations link. From there, you should be able to either download the annual report in PDF form or find information on how to contact shareholder services and request a copy in the mail.
If that doesn't work, call the company's headquarters and ask to speak to shareholder relations.
The Form 10-K Filing
You already understand the details of the Form 10-K. This is an annual disclosure that publicly traded companies must file with the SEC within a few months following the close of their fiscal year.
Most of the time, the annual report contains easy-to-digest information in a pleasant format. The 10-K, in contrast, often has the nitty, gritty, everything-and-the-kitchen-sink data you may want to research, breaking down, often in much more detail, everything from the geographic source of revenue to the maturity schedule of bonds that have been issued. Some investors find the 10-K impenetrable but if you love finance, the occasional challenge of piecing together the cogs and gears of a business, and enjoy understanding how it is structured, it is invaluable. Truly complex businesses will often have 10-K documents that run several hundred pages long.
Sometimes, you run into a company that has no financial statements or other disclosures in the Form 10-K but, instead, has a passage that reads something along the lines of, "incorporated herein by reference". This means that the information has been released elsewhere, such as in the annual report, and they want you to go read it there. Even if this is the case, it is still worth it to get a copy. You can find this by contacting the company, visiting its website, or checking the Securities and Exchange Commission website.
The Form 10-Q Filing
The Form 10-Q is similar to the Form 10-K except that it is filed quarterly, or three times a year (the 10-K will take it's place one quarter of the year).
It contains a lot less detail than the 10-K due to the abbreviated nature of the measurement period, among other things, but can be particularly useful from time to time, under certain circumstances. Specifically, the Form 10-Q can give insight into changes that are happening in a business long before those changes show up in the earnings figures. You notice things like heavy net share repurchases during the year that haven't, yet, been figured into the annualized earnings per share figures due to the way diluted earnings per share is calculated. You see that the inventory turnover is getting better or worse or that the accounts receivable turnover is improving or flashing warning signs that there may be a credit problem with customers. You notice changes in working capital. You learn about lawsuits and potential legal risks for which reserves haven't been established.
You Can Use Data Aggregation Services from Financial Portals But It's Still Better To Go To The Source
These days, a lot of investors rely on the balance sheet, income statement, and cash flow statement as found on financial portals; data aggregated from SEC filings and automatically fed into Internet sites that make it available for free to drive advertising revenue, such as Yahoo! Finance. These can be great for back-of-the-envelope, quick analysis but be careful about making major decisions based on such sources. For one thing, errors are still common, especially when dealing with foreign companies or companies that have unconventional dual-class share structures. I can't tell you how many times I've seen the dividend yield incorrectly calculated or the price-to-earnings ratio outright wrong.
For another, financial summaries are too limited in scope. It's still important to go read the annual report, 10-K and 10-Q yourself because there are all sorts of things that cannot be included in these convenient reproductions. Take a former blue-chip stock like AIG prior to the Great Recession in 2008-2009 when it collapsed. A quick read of the annual report and you'd have been terrified of the derivative exposure (I still keep a copy of mine in my records, noting how I couldn't bring myself to own the business because I couldn't estimate how bad the potential liabilities would be). That didn't show up on the financial sites, where all you saw was booming net income, growing assets, and expanding cash flow. You must never forget that you are buying ownership in a business, in the case of stock investors, or lending money to a business, in the case of bond investors. There are no shortcuts. You have to do the work and understand the risk you are taking on to collect those dividends, interest, and rents.
Be Sure to Request the Annual Report, 10-K, and 10-Q of a Company's Competitors If You Want To Understand Its Strengths and Weaknesses Compared To Other Firms In Its Sector or Industry
Another trick you'll want to employ in your own analysis is to request the annual report, 10-K, and 10-Q of companies in the same sector or industry of the firm in which you are interested. For example, it can help you understand an oil major better if you are studying all of the oil majors at the same time. You can analyze the financial statements and ask yourself, "What's different?" You'll discover how firms have different capital structures. You'll be able to scrutinize the DuPont ROE variables and see what is driving returns. You might be able to gain insight into which firms will come out on top and which are doomed to oblivion by looking at things like the trend in sales per square foot and interest coverage ratios.
With the other firms fresh in your mind, differences, both positive and negative, are more likely to stand out and get your attention. This is true for every sector and industry in existence. It doesn't matter if you are reading the annual reports and 10-K Filings of chocolate companies, automobile manufacturers, newspapers, banks, gold mine operators, real estate developers, packaged food giants, soda bottlers, farm equipment suppliers, coffee shops, discount retailers, or theme parks. If one business mentions a new accounting rule that is going to influence results substantially, and another only glosses over it, that would raise red flags for the latter firm in my mind. Likewise, one company may point out a compelling opportunity the industry is facing, while other, more conservative firms don't expand on anything more than the results produced during the reporting period.