How to Read Financial Statements

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.

These three financial statements can give you quite the picture of a company. But even they are far from all there is to financial statements. The official forms that contain financial information for companies contain an extraordinary amount of information on them - not just how the company has performed, but indications for what the future could hold.

The above-mentioned statements tend to show up in even larges forms filed by the company to the Securities & Exchange Commission (SEC). These are exceptionally important tools for investors to determine what the outlook on the company - and thus their portfolio - could be.

So, what are these big important official forms you should know if you're a shareholder for a company? Here are the 3 most important SEC-related forms you should be aware of:

  • 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.

What is a Form 10-K?

This official form, filed to the SEC, will include On its face of the 10-K 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."

For a 10-K, the company will divide their report into 4 smaller parts

  • Part I
    • Within Part I will be a description of the business, including its intended purpose and strategy. This section also includes relevant risk factors and how they apply to the company, a disclosure of any significant properties the company owns, and if relevant, the business may also respond to SEC complaints that were made in previous reports.
  • Part II
    • Part II has important information about the company's stock, such as the market it trades on and the number of shareholders. It also has management's discussion and their own analysis of the financial situation and risks they face, disclosures about their exposure to market risk, and financial statements and supplementary data. This is where aforementioned statements (income statement, balance sheet, statement of cash flows) would go.
  • Part III
    • In Part III, you'll find information on executives that include compensation and background. Often, this information is relegated to a separate sheet called a "proxy sheet."
  • Part IV
    • Part IV has a list of exhibits and financial statements included in the 10-K.

These parts are further divided within each part into "items," making it more organized to read.

What is a 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.

Because it isn't for as long a period, you won't necessarily get a better long-term picture of how the business is doing, but analyzing a 10-Q offers other benefits to investors. It can help make them more aware of risks and changes going on at a more convenient, relevant point.

What is an 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. Netflix, for example, links to an annual report via their Investor Relations page, but it's just their 10-K report again with no additional frills.

On the other hand, some companies, such as Nike, put together a professionally designed annual report that incorporates a message to shareholders in addition to the 10-K ; the letter focuses on highlighting a lot of the company's accomplishments (such as revenue and EPS increases), where they feel the company succeeded best over the year, and in Nike's case, how athletes they partner with performed. There may also be discussion of what they plan for the future.

Many companies choose to do this, whether for aesthetic purposes or to please the shareholders. Another example is 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 for Reading Financial Statements

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 2017 report of independent accountants for Netflix):

We have audited the accompanying consolidated balance sheets of Netflix, Inc. (the Company) as of December 31, 2017 and 2016, and the related consolidated statements of operations, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017. In our opinion, the financial statements present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2017 and 2016, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated January 29, 2018 expressed an unqualified opinion thereon.

As you can see, the accounting firm that performed this audit (in this case, Ernst & Young LLP) determined independently that there were no issues or red flags.

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, unless of course the company had either an outstanding or catastrophically bad year. 

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. Look closely. What companies were these people working at prior to this, and how reputable have they been?

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. For example, the strides technology has made and can make will impact the plans and competition between companies in the tech 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. The entirety of these forms are integral to understanding and analyzing your investment.

At the time of publication, Rothbort was long AAPL, AMLN, DUK, and RUTH, although positions can change at any time.

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