How you read an annual report depends upon your purpose. As an investor, your purpose may be to assess profitability, survivability, growth, stability, dividends, potential problems, risks or other factors which may affect your investment in that company. The annual report provides a convenient way to monitor the progress of a company. If you own shares in the company you should receive a copy of their annual report in the mail from your broker; if you don't, you can request one or view it online at edgar.sec.gov.
Annual reports are a corporate "work of art" and should not be read like a normal book. There is no need to read the report cover to cover. The first pages are a colorful, non-technical overview of the company's objectives and how well it's meeting them. This should be taken with a grain of salt, because it's marketing literature from the company, designed to put their best foot forward. The pages in the back are for number-crunching and heavy-duty research. Reading annual reports together year to year creates a kind of timeline for the company. You can learn a lot by reading about how the company changed their business model or carried out their desired plans from one year to the next.
There are nine sections in most annual reports. Not all reports will have all the sections or the same type and amount of information. Here are the sections, what you'll find in each, and questions you should ask yourself:
- Chairman of the Board Letter: Should cover changing conditions, previous objectives met or missed and upcoming objectives, and actions taken or not to be taken. Is it well written? Read between the lines; what is being apologized for?
- Sales and Marketing: Should cover what the company sells, how, where and when. Is it clear where it's making most of its money presently? Is the scope of lines, divisions and operations clear?
- 10 Year Summary of Financial Figures: Is this included? Have revenues and profits increased each year?
- Management Discussion and Analysis: Is it a clear discussion of significant financial trends over the past few years? How candid and accurate is it?
- CPA Opinion Letter: Written by the CPA firm as an opinion on the company's financials. Is it a well-respected firm? What did they have to say about the company's numbers?
- Financial Statements: Check sales, profits, R&D spending, inventory and debt levels over time. Read the footnotes to ferret out other information.
- Subsidiaries, Brands and Addresses: Where is their headquarters? Is it clear what lines, brand names the company has and what their overseas distribution network is?
- List of Directors and Officers: How many directors are insiders and how many are outsiders (a good mix is ideal)? Are the directors well-known and respected? Are there an unusual number of directors (5 to 12 is typical)?
- Stock Price History: General trend of price over time. Up or down? On which exchange is the company listed? Do they have a history of paying dividends?
- Financial Statements: Most of the information you'll be concerned with in the annual report is located in the financial statements (the balance sheets, the cash flow statements, and the income statements), which are discussed in detail in the Financial Statements section.