A publicly-listed company is required to file financial reports quarterly and annually.
An investor browsing through the different SEC filings will often wonder does these 10-k’s (annual reports) and 10-Q’s (quarterly reports) means.
Why is it important to read and be able to understand the financial reports that a company submits regularly?
To answer that question, we will give you an overview on the sections of the financial reports and what it means to investors.
Before anything else, look at the balance sheet
The balance sheet is the first financial report that you will see. It comes before the income statement, cash flow statement and the notes to financial statements. It is there for a reason.
This report gives you an overview of the financial position of the company – the assets, liabilities and shareholder’s net worth. A company with a lot of debt vis-à-vis with its assets may not be a good investment after all. So, it’s an easy pass.
Now, look at the income statement to see if the company is earning..
Once you have realized that the company does not have debt problems, you can now look at how much is the company is earning.
At this point, you can now proceed to the income statement.
The income statement tells you the source of the income of the company and the itemized expenses that it incurs.
If the total income exceeds the total expenses, it means the company is earning money. Conversely, if total income is less than expenses, it means that the company is losing money.
…but you also have to look at the money trail through the cash flow statement
This is probably the financial report that most investors ignored. They often skip the cash flow statement since most investors stop at the income statement to assess the viability of the company.
However, the cash flow statement is vital to investment decisions. A cash flow statement contains the cash generated from operations, where the company is investing and the source of the company’s finances.
A negative cash flow from operations but positive income could mean a company has a problem of collecting cash. The cash flow statement will confirm whether the income earned, as stated in the income statement is real or not.
But wait there’s something you missed out – notes to financial statements
There are only few investors who bother to read the notes to financial statements. These are supplementary data to the balance sheet, income statement and cash flow statement.
Some financial analysts would advise investors to read the financial reports backward – start with the notes to financial statements first. The reason is that some companies tend to hide their liabilities or problems in the notes to financial statements.
An example would be a probably legal case that would cost a big amount to the company. This is something that may have an impact to the company, but could not be quantified since it has not yet been executive.
The landmines are probably hidden in the notes to financial statements. Investors – watch out!
Management Discussion and Analysis section puts the pieces together…
This section is found on the first few pages of the annual report. While the numbers in the financial reports paints a story, the management discussion confirms the story.
The company’s management discusses what happened during the year and where the company will be heading in the future. It gives the investor an overview of what to expect in the future.
A word of advice
The investor will just need to follow the steps that we have discussed above. If the balance sheet does not look good, there is no need to go through other financial reports.
While financial reports give you an overview of what happened during the year, it only gives you a limited view of the future. After all, past performance does not guarantee future results.