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Interpreting annual reports
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September 1, 1999: 9:33 a.m. ET
These yearly accounts can yield clues about where your investment is headed
By Staff Writer Nicole Jacoby
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NEW YORK (CNNfn) - Their glossy covers and elaborate illustrations are meant to be welcoming. But open the pages of almost any company's annual report and chances are you'll be intimidated.
Learning to interpret this yearly document is no easy task. But by weeding out the relevant from the immaterial, you may be able to glean important information about your investment in a company.
"In an annual report, you'll have a great deal of information that is of value, some that has some sort of value, and some that is worthless," said Richard Loth, author of "How to Profit from Reading Annual Reports." "So you have to be discerning."
The anatomy of an annual report
Although some companies will put more effort into aesthetics than others, the basic structure of most annual reports is generally the same.
All annual reports review a company's operations for the past year and usually begin with a letter from the company's chairman highlighting recent company successes and future plans. This welcome is often followed by a section on the company's philosophy and detailed reports on each segment of the company's operations.
Another section discusses management and reviews the company's strategies.
"As long as you understand that this is a heavy PR job, it can be informative," said Loth. "You can get a good idea of what the company is doing."
An auditor's letter is also included to confirm that the company's financial statements have been found to be fair and accurate by an outside source.
But the heart of the annual report -- and the most valuable to investors -- is the company's financial statement.
"The financial highlights offered at the beginning of the report tend to focus on what they (the company) want you to see -- but that's just an appetizer," said Loth. "The second course -- the big plate of meat and potatoes -- is the financial statement."
Dissecting the 'meat'
The financial statement is divided into three primary categories: the balance sheet, the income statement and the cash flow statement.
The balance sheet in some ways is a simple formula. It represents the company's financial position in a given period of time, in this case one year, and summarizes all transactions in that time frame.
In short, a balance sheet represents the company's assets, liabilities and equity.
It may go without saying but -- to start off -- investors should make sure the balance sheet actually balances, that asset values equal the sum of liabilities and equity.
You should also take a close look at the section of assets that deals with accounts receivable -- credit extended to customers who have yet to pay for a purchase or service -- and inventories.
Those two components of the balance sheet can yield important clues about a company, says Loth.
"You really need to look at the turnover (of these two items)," Loth said. "How fast is the company turning over receivables and inventories into cash compared to its competitors in the industry?"
This is important because accounts receivable that move faster than sales may indicate the company is being lax with its collection policies or that it is "giving away" its goods in order to boost short-term sales.
Low inventory levels can also be a problem because it may make it difficult for the company to meet demand, resulting in losing sales. On the flip side, inventory levels that are too high may be a signal that the company cannot generate sales.
"Inventory levels vary by industry so it is important to know the environment in which the company operates," said Wayne Thorp, assistant financial analyst at the American Association of Individual Investors. Be careful not to compare apples and oranges when evaluating annual reports of different companies.
Liabilities reflect the financial obligations the company faces in the next year or operating cycle.
"If a company cannot honor these obligations, it should serve as a warning sign," said Thorp.
Earnings, earnings, earnings
The income statement is one of the most widely watched segments of the annual report, since profits are most likely to determine a stock's value in the long run.
When evaluating earnings, be sure to compare figures over the course of several years, so you can compare trends in sales and expenses. All the various items on the income statement -- cost of goods, earnings per share and net income -- should move in relative tandem with sales.
A company whose earnings are increasing while sales are dropping may "indicate that a company is bettering its operating efficiency," said Thorp. "However, squeezing profits from improved efficiency can only last for so long."
Ultimately, a company will need to bolster its sales to achieve better earnings, says Thorp.
Assessing cash flow
An annual report's cash flow statement reveals the amount of cash being used and generated within the company during a period of time.
This part of the financial statement is very important, contends Loth, but is often "glossed over" despite its simplicity.
"Cash is king. Without it, you don't pay bills. You don't acquire new companies," said Loth. "You can't do that with net earnings."
When assessing cash flow, be sure to focus in on operating cash flow. This number excludes non-cash charges, such as depreciation and amortization, and basically represents a company's ability to generate cash from day-to-day operations.
Ideally, a company's operating cash flow should exceed its capital expenditures or investing cash flow, which are funds the company invests in itself in the form of new technology or other improvements.
Free cash flow deducts dividend payments in addition to capital expenditures. This figure represents the excess cash a company has to use at its discretion.
"With strong positive free cash flow, debt can be retired, new products developed and dividend payments increased," said Thorp.
Reading the fine print
Footnotes can be another overwhelming area in an annual report. Often running several paragraphs, notes can contain a plethora of information -- most of which may be rather innocuous.
But at least one area does warrant closer examination, says Thorp.
"One of the big things a company's footnotes can reveal is whether or not the company faces pending litigation: is the company facing the prospects of paying a large settlement in a lawsuit?" he said. "The problem with contingencies is that the recognition and measurement is subjective at best."
Footnotes can also give you a sense of the assumptions management is operating under, such as the accounting practices they use. These assumptions can play a big role in how the statements are put together to begin with.
Starting out
Now that you're ready to tackle an annual report, you'll have to know how to get a hold of one.
The investor relations department of any public company should be able to send you a copy free of charge and many annual reports can now also be accessed online, through services offered by The Annual Reports Library, Report Gallery, and The Public Register's Annual Report Service.
If the mere sight of footnotes and balance sheets has left you demoralized, hang in there. Your perseverance will eventually pay off.
"You have to think of it as a long-term proposition," said Loth. "You need to take it in bits and pieces at a time. Don't try and absorb it all at once." 
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