How to Read Financial Statements

NEW YORK ( TheStreet) -- Last time, I presented a guide to understanding earnings calls. The most anticipated and recognized facet of a company's financial report during a typical earnings call is its earnings per share (EPS). The EPS (also listed as "net income applicable to common shares on a fully diluted basis") is referred to as the "bottom line" because it is the bottom line of a company's profit and loss statement (P&L, also known as the income statement).

While the EPS captures the media headlines and is the most-sought-after metric, it is only part of one of the three major components of a company's financial documentation that is necessary to understanding both the company's performance and its financial condition. The other two major financial statements are the balance sheet and the statement of cash flows.

In the upcoming weeks, I will highlight each of the individual financial statements. The objective of this series of lessons is to provide the necessary tools to ascertain financial information and understand those reports without having to possess a CPA (certified public accountant) or CFA (chartered financial analyst) designation. (However, it is the role of the CPA to audit and certify the financial statements that will provide the independent account.)

This week, let's kick off this multipart examination of financial statements by looking at the annual report and 10-K for a lesson on financial and regulatory reporting.

Getting Started:

As is often the case with any research project, we start by aggregating information and materials that will provide the basis for our financial investigation. This prompts the questions: What should I look for? and where can I find it?

Here is our punch list:

-- Form 10-K
-- Form 10-Q
-- Annual Report

These documents can usually be found in the "Investor Relations" section of a company's Web site.

Form 10-K

This is an official filing made by the company to the Securities & Exchange Commission (SEC). On the face of the 10-K will be a statement to this effect:

"Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended 1996 ."

The 10-K will contain the following sections:

-- An overview of the company and selected financial data
-- Director and senior management information including executive compensation, as well as signatures by senior management and the directors
-- Consolidated financial statement including the Report of Independent Registered Public Accounting Firm
-- Notes to the financial statements

Form 10-Q

This is the quarterly and slimmed-down version of the 10-K. It typically only includes unaudited financial statements, notes to the financial statements and a management discussion.

Annual Report

This publication is sent to all shareholders and is available from the company for prospective investors. The annual report varies from company to company. Some companies, such as Ruth's Chris Steak House, just slap a glossy cover over a 10-K and call that an annual report.

On the other hand, some companies, such as Amylin Pharmaceuticals, put together a professionally designed annual report that incorporates a message to shareholders; a business overview featuring (but not limited to) the company's management, products, operations and new endeavors; the auditors' report; consolidated financial statements; and notes to all of those statements.

Yet another spin is the summary annual report as presented by Duke Energy. Duke issues a summary annual report with plenty of gloss, a business overview and financial statements. However, ultimately, the Duke report refers readers to its 10-K for more details.

Step by Step:

Now that you know what reports to obtain, let's walk through what you should do with them -- before you even get to analyzing the financials.

Step 1. Read the Report From the Independent Accounts

You want to ensure that the company has received an unqualified report. This means that the company has complied with Generally Accepted Accounting Principles (GAAP) and that the auditors found no material items that might cause an exception to GAAP and no financial conditions that might indicate that there are questions that the company can exist as a going concern.

An unqualified report would contain language along these lines (as taken directly from the 2006 report of independent accountants for Amylin):

We have audited the accompanying consolidated balance sheets of Amylin Pharmaceuticals, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Amylin Pharmaceuticals, Inc., at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, Amylin Pharmaceuticals, Inc., changed its method of accounting for share-based payments in accordance with Statement of Financial Accounting Standards No. 123R, Share-Based Payment.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Amylin Pharmaceuticals, Inc.'s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2007 expressed an unqualified opinion thereon.

As you can see, there are no issues or red flags. The one accounting change ("Amylin Pharmaceuticals, Inc., changed its method of accounting for share-based payments...") was of a material enough nature to include in the report, but once you read the note to the financial statement you will understand that it is not a problem to be concerned with.

Step 2. Read the Letter From the CEO

The CEO (chief executive officer) is the leader of a company. In that capacity, not only does the CEO manage the current operations of the company, but he also sets the vision for the future. Thus, as an investor, what you want to hear from the CEO is where the company has come from, where it is and where it is going. On one end of the spectrum, some CEOs will use this section to cheerlead. On the other end, some will use it to be cathartic and talk about mistakes made and future challenges. Most CEOs' letters are somewhere in between.

Step 3. Check Out the Senior Management Team and the Board of Directors

The management team and board of directors will tell you who is operating and who is looking over the company. High on investor and regulator watch lists are concerns over corporate governance. You want to avoid companies with managers or board member who have tarnished or shaky backgrounds. As an example of the flip side of this, while the board of directors at Apple has had to contend with options back-dating issues, the background of its members is highly reputable.

Step 4. Read the Business Overview

Companies will change over time. Its products and businesses will go through cyclical phases. Demand for old and new products and services will dictate future strategy. Economic and other market conditions will affect a company and industry.

Expansion and growth are factors that investors will pay for. Reading the business overview will give you an idea of the company's current products, competitive position and future plans.

As you can see, there are some important things that you should do before you analyze a single number.

This week's homework: What is your single biggest stock holding? Obtain an annual report and 10-K for that company, read the information within these documents (as I've outlined in this lesson), and formulate your initial take on the company's performance and its financial condition.
At the time of publication, Rothbort was long AAPL, AMLN, DUK, and RUTH, although positions can change at any time.