How to Decipher an Annual Report

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I recently looked at the annual report for a company and felt a little intimidated reading through it. Any ideas that would help a new investor learn how to get the most out of reading an annual report?-- W.B.F. (via Stockpickr Answers)

For new investors, a company's annual report can seem anything but inviting. The numerous pages of cryptic numbers and graphs you'll encounter can make the investing world seem a bit out of reach. Believe it or not though, the annual report isn't some alien document. It's something that you can get a grasp of in no time.

For starters, what exactly is an annual report?

An annual report is a document that all public companies are required to file once per year. The annual report outlines how the company is doing financially, what their key businesses are, and what's in store for the future. All of this information makes annual reports a hugely useful tool for individual investors.

The term "annual report" is sometimes used interchangeably with 10-K. What's the difference? The 10-K is the legal document that public companies file every year with the SEC, whereas the "annual report" tends to be filled with less legalese and more glossy pictures.

Not all public companies issue a glossy annual report, but the ones that do usually include the 10-K as part of it. Just think of the actual annual report as the whole thing, and you should be all right.

How to Find Annual Reports

Annual reports are freely available online, either from the SEC's EDGAR Web site or from the company's investor relations section of their Web site. Many companies are also happy to mail you a free annual report if you just ask.

Another filing out there is the 10-Q, which is filed by public companies every quarter. You should look at the 10-Q much in the same way you would an annual report with one exception: 10-Qs aren't necessarily audited, so financials statements might not be in line with GAAP (see " Audits, Financial Statements, and You").

How to Dissect an Annual Report

Now that you know what an annual report is and where you can find one, let's look at what you need to know to decipher this staple in the investor's arsenal.

First, is the annual report's glossy "front matter." Since this stuff is pumped out by the company's public relations (or PR) machine, is it really worth reading? The short answer is yes, at least, at a glance. The glossy section of the report usually has a letter from management that's easier to read than what you'll find in the 10-K. Also, the glossy content can give you some decent snapshots at the company's performance and plans.

As technology has changed, so has the glossy annual report. For the online version of their 2007 annual report, Invitrogen ( IVGN) decided to implement multimedia and interactive features to give investors a better look at the company, including a full-motion welcome from the vice president of investor relations.

While Web features like Invitrogen's video interviews with the CEO can be a great asset to investors, few things can compare to the cold, hard data you'll find in the 10-K. For Invitrogen's 10-K, check out this page on Yahoo! Finance.

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.

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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