An annual financial report is a document that a company prepares for the purpose of giving an account of its earnings and other financial data. A company may prepare a financial report for internal operational reference, to inform current and prospective investors and to provide legally required information to the government for the purpose of taxation. Those who are considering buying stock or bonds from a particular company and those who already own such investment instruments should learn to read annual financial reports (aka Form 10-K) for the companies into which they either have already invested or are considering making an investment. While formats vary, most annual financial reports contain the same basic information. Read on to find out how to read a company's annual financial report.
A company's balance sheet, also called a statement of financial position, is the simplest summation of its current financial health. The balance sheet typically consists of the following items:
- Assets: Everything the company owns.
- Liabilities: Everything the company owes.
Typically, as long as a company's assets are of significantly greater value than its liabilities, it is in good financial shape. Some companies, however especially new companies, may still be in good financial shape even if their liabilities outweigh their assets. However, this can only be true so long as the company's income is more than its debt service payments.
A company's income statement conveys an overall assessment of its ability to make money. Such statements usually consist of the following items:
- Operating income: Total revenue from normal business operations
- Operating expenses: Total expenses from normal business operations
- Investment income: Total income from investments the company has made
- Interest payments: Total amount the company must pay out in interest to service debts
The income statement shows the total amount of cash the company brings in. After subtracting all expenses from that, it gives a figure for net income. It then divides this by the total number of shares, showing the earnings per share.
Shareholder Equity Statement
The shareholder equity statement in an annual financial report illustrates the change in total shareholder equity in the company. This statement takes four basic things into account:
- Net income: The company's income as related by the income statement
- Dividends paid: The cash that the company regularly pays out to investors
- Retained earnings: Company earnings not distributed as dividends
- Stock issued: The total amount in new shares of stock that the company has issued to investors
Cash Flow Statement
The cash flow statement in an annual financial report gives an account of all cash moving in and out of a company every year. The cash flow statement takes three basic things into account:
- Operations activities: All cash that the company brings in and spends through its normal operations
- Investment activities: All cash that the company brings in or loses by making investments
- Financing activities: All cash that the company brings in through stock issuance or loans
The principal difference between what the cash flow statement shows and what the income statement shows is that the cash flow statement is not an illustration of long-term viability through the ability to generate profits. Rather, it is an illustration of short-term viability through the ability to bring in cash that can be used in operations -- even if the raising of that cash results in an accrual of debt or a transfer of equity.
Key Financial Ratios
The best way to analyze the data found on an annual financial report is by applying key financial ratios. Here are some ratios you may use to determine the investment viability of a company's stock:
- Net Working Capital Ratio = (Current Assets - Current Liabilities) / Total Assets
- Profit Margin = Net Income / Sales
- Current Ratio = Current Assets / Current Liabilities
- Debt Ratio = Total Liabilities / Total Assets
- Debt-Equity Ratio = Total Liabilities / Total Stockholder Equity
- Cash Flow-to-Debt Ratio = Operating Cash Flow / Total Debt
- Price Earnings Ratio (or PE Ratio) = Stock Price / Earnings per Share
- Dividend Yield = Dividends per Share / Stock Price
- Asset Turnover Ratio = Total Revenue / Total Assets
This is not an exhaustive list. Many other ratios are also used. After calculating such ratios, analysts may also perform other calculations by combining these ratios together. For example, to calculate ROA (Return on Assets), analysts multiply the Asset Turnover Ratio by the Profit Margin.
Analyzing The Ratios
Depending on the type of company in question, the type of investment being made, the industry, the market, etc., savvy investors use different ways of judging investment viability. In one industry, a company with a profit margin of 0.5:1 may be seen as a high performer, while in another industry, this may not necessarily be the case. There is no single standard for all companies in all markets and industries. To make an educated judgment on how well a company is performing, it is usually necessary to compare its numbers against those of other companies with similar operations and circumstances.