How to Decipher an Annual Report

The 10-K

The 10-K can usually be split into four parts: the business, the financials, leadership and fine print.

Part 1. Business, Risks and Legal: The first part of the 10-K usually includes information about a company's core business, risks to that business, properties the company owns or leases, and the legal proceedings that the company is dealing with. This is a big section, so what should you take away from it?

If you're not familiar with the company, it's a good idea to give the business section a good read. Afterall, it's not really good form to invest in a company if you don't understand how they make their money.

Risks are another thing you'll want to take a look at, but don't fret too much if you see a long list. Companies list all foreseeable risks on the 10-K, which means that even very unlikely risks may be mentioned. In LeapFrog's LF 2006 annual report, they warn that "If [LeapFrog] fails to predict consumer preferences and trends accurately, develop and introduce new products rapidly or enhance and extend our existing core products, our sales will suffer."

In other words, if they don't sell products consumers will buy, sales will fall.

As you can see, it's your job as investor to separate the important stuff from the legalese. The same is largely true of the legal section. Companies have to list all of their ongoing legal actions along with how they think each will affect the company, so don't pay too much attention to suits that won't affect your analysis.

Part 2. Financial Statements: This is where you'll find the company's financial statements, which as you may have heard are pretty important if you're trying to determine if a company looks like a good investment.

This is definitely a section not to miss, but it's one that can look pretty intimidating to a new investor. So before you try to take on these financial statements,, take a look at this "Getting Started" series on analyzing financial statements: "The Balance Sheet," "The Income Statement" and "The Statement of Cash Flows."

Part 3. Leadership: The leadership section takes a look at the company's management and board of directors. It usually gives short bios on the people at the helm, as well as other key information like executive compensation and related party transactions.

Sometimes, you won't find that much information here. If that's the case, check out the company's "Proxy Statement" instead.

Part 4. The Fine Print: You're not done yet! If you close that annual report now, you'll be missing out on one of the most important parts of the report: the fine print. This is where you'll find "Footnotes" and "Exhibits" to financial statements that can really be useful in the investment decision-making process.

Toward the end of the 10-K, you'll also find the "Auditor's Report" (see "Audits, Financial Statements, and You").

How to Cut the Junk

Remember to take the annual report with a grain of salt. It may be a great resource, but remember, it's also filled with a lot of extra information (legalese, for example), that's really not relevant to your investment decision.

Cut the junk by focusing mainly on the important points mentioned, and you'll cut down on your annual report workload.

Also, annual reports won't tell you everything. They're publicly available, so you can bet that you won't find any secret plans for a revolutionary new product in Apple's AAPL 10-K, or Google's GOOG hush-hush plans on what they plan to do with their potential radio spectrum.