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Understanding a shareholder report
5 Tips: Reading an annual report
March 4, 2004: 9:43 AM EST
By Gerri Willis, CNN/Money contributing columnist

NEW YORK (CNN/Money) - It's that time of year again: when companies start sending out their annual reports in mass. Public companies are required by law to release their financials to individual investors. And there are about 15,000 public companies.

Now, if you're like many people, deciphering the code of the annual report can be simply too much trouble. After all, once you get past the glossy pictures, there are simply rows and rows of numbers. So, what five things should you absolutely check? Here are today's five tips.

1. Start with the letter to the shareholder.

For a nice overview of the company's situation, check out the "letter to the shareholder." This is usually found towards the front of the annual report.

This is the place where the company's top management team outlines how the company performed and its goals and strategies. This is usually in terms that the average investor can understand.

For example, in Starbucks' 2003 annual report, the letter to the shareholders laid out how many locations it has worldwide, says its revenue rose 24 percent from a year ago, and saw same-store sales growth of 8 percent. Same-store sales represent locations that have been open for at least one year. It is an important measure of the company's progress.

The company also discusses plans for its employees, recent awards it received, the introduction of several new beverages, and says "we are passionately committed to our ultimate goal to have approximately 25,000 Starbucks locations worldwide."

Make sure to read the language carefully. For example, in Sun Microsystems' 2003 annual report, President and CEO Scott McNealy says "we're not yet where we want to be, but we believe our vision and strategy will take us there." He also says "clearly, market conditions were once again challenging, but our team has positioned the company well for fiscal 2004 and beyond."

While McNealy is upbeat about the company's future he is also pointing out that the company is not operating under the best case scenario. And if you know for a fact that the company you are investing in had a bad year, be concerned if you get an annual report with a rosy letter to the shareholder.

2. Take a look at the income statement.

The income statement is exactly as it sounds. It summarizes the company's revenue from product and services and the expenses that offset those sales. Ideally, you'll want to see steady or accelerating revenue growth.

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CNNfn's Gerri Willis shares five tips on what you need to know when it comes to reading annual reports.

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"Investing for Dummies" says if a company's revenue is growing slowly or not at all, make sure to inquire why. Ask, is it because of poor service, weak product performance, increased competition or ineffective marketing? If you are invested in a company that operates multiple divisions, make sure you are aware of the different units and look to see which ones are bringing in the sales.

Now, while obviously it's good news if a company is making money, you can bet this company will also have expenses it needs to cover. Check to see if the company's expenses are growing faster than the revenue coming in. If this is the case, the company's bottom line will weaken.

"Investing for Dummies" also points out that as a well-managed and financially healthy company grows, expenses as a percentage of revenue should decrease. Among the possible expenses a company has are advertising, equipment, rent, employee salary and the costs of goods sold. You can also expect to see the term "earnings per share." Higher profits per share generally boost the company's stock price.

3. Figure out the ratios.

The other major statement to look at is the balance sheet. Instead of measuring performance over the years as the income statement does, the balance sheet is a snapshot of the company at a moment in time. Using the balance sheet, you can quickly determine whether the company is solvent or not.

Start by developing a current ratio from two numbers, current assets and liabilities. (Assets are anything of value to the company. Liabilities are defined as the money the company owes others.) Divide current assets by current liabilities. If the number is below 1.5, then your company is poised for trouble. Too large a number is bad news too, since it could indicate that a company is failing to reinvest in its business.

It also pays to check the Quick Ratio. The quick ratio is current assets minus inventories divided by current liabilities. By taking inventories out of the equation, you can check and see if a company has sufficient liquid assets to meet short-term operating needs. Look for a quick ratio above 1.0 to ensure that there is enough cash on hand.

4. Go deeper.

If you really want to know where the problems lie, page to the back of the glossy and check out the footnotes of the annual report. This is where the company is expected to elaborate and explain in more detail what's behind the numbers.

The problem is that the notes are difficult to read because they are often prepared by accountants and lawyers. And, of course, sometimes the language is obtuse because the company's operators are trying to hide some sort of bad news.

Remember, the footnotes are where you'll find out about underfunded pension plans or derivatives exposure. Also, if earnings are up, consider the fact they may be up because of a special event that won't happen again next year. Chances are the footnotes will have the answer.

One more spot you'll want to check out: the auditor's opinion. A company's financial statements must be reviewed and audited by a qualified Certified Public Accountant (CPA).

Louis Thompson of the National Investor Relations Institute says you'll want to look to see if there has been any restatement by the company in its financials and find out why.

Thompson also points out that auditing companies must now answer to the Public Companies Accounting Oversight Board (PCAOB). This organization was formed in 2002 under the Sarbanes-Oxley Act to raise issue with accounting firms and monitor their work. In some ways this should help investor confidence.

5. Dive into the 10-K.

The 10-K is a similar document to the annual report in that both summarize how the company did over the past year. However, they serve slightly different roles.

A company is required to send a 10-K to the SEC. It must follow strict legal guidelines. The annual report will usually arrive as a glossy, flashy publication full of pictures and narratives. While chances are you'll receive both the annual report and the 10-K, companies are not required to send both to the investor. In fact, small to mid-cap companies often will not send an annual report and will just send the 10-K. It is also possible to find these financial statements online at the company's Web site.

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Another good place to go: Management's Discussion and Analysis which appears in both the 10-K and the annual report. Late last year the Securities and Exchange Commission issued a release providing guidance to companies on their MD&A. The SEC says companies must enable investors to see the company "through the eyes of management." It also expects companies to enhance overall financial disclosure to investors.

One example of what is found in the MD&A: checking out Federated's 2003 MD&A, the retail giant discusses the closing of certain stores as well as the integration of others.


Gerri Willis is the personal finance editor for CNN Business News. Willis also is co-host of CNNfn's The FlipSide, weekdays from 11 a.m. to 12:30 p.m. (ET). E-mail comments to 5tips@cnnfn.com.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.