Last time, I went through four things you need to look at in the annual report.
- Beware fancy charts in the annual reports.
- Use the letter to shareholders as a screen for CEO trustworthiness.
- Do not trust auditors.
- Check consistency of footnotes.
Prepare to Read ActivelyDo you want to read the 10-K faster and be able to take in more information in one go?
The single best piece of advice I have is for you to either print out the filing or have it in an editable format so that you can write notes onto it directly.
Write notes as you go along. Even drawing a big question mark around a certain statement goes a long way when you review the report again.
This is called active reading.
Trust me, reading 10-Ks suddenly becomes more fun because it feels like you are uncovering hidden information.
The first time will take a little longer, but that’s only because you are processing the information deeply and by the time you review it a second time, you will fly through it.
The best way to waste time is to “surf” the filings. Without actively engaging with what is written on the report, you will wander aimlessly, waste time and miss good info.
Get your pens, highlighters or fingers ready.
Here is the cheat sheet, courtesy of the SEC, of how to read the 10k.
How the 10-K is Broken DownThe 10-K can be broken down into four big parts and I will cover the sections you will see most often.
- Part 1: Company overview and description
- Part 2: Business Discussion and Financial Data
- Part 3: Insiders and Related Parties
- Part 4: Full financial Statements and Footnotes
Item 1: Company OperationsThis is the easiest part to read in the 10-K.
Don’t know what the company does? Then read this section.
Still don’t know?
Then move onto the next company that you can understand.
You do not have to fight and struggle your way through. There are plenty of ideas out there.
But if you know what you are reading, then move onto the next section.
Item 1A: Risk Factors
This is one of the best sections to read as it lists all the risks that the company believes it is subject to.
Companies even disclose weather risks and other details you may think are minor.
What you need to look for first are the major risks such as whether a company is dependent on one customer. If so, what happens if the company cancels the contract? Ask yourself questions as you go along and keep jotting down those notes.
Item 1B: Unresolved Staff CommentsThese are essentially SEC staff comments in a 10-K document that has not been answered or resolved by the company for more than 180 days before the end of the fiscal year.
The SEC comments should be disclosed if it has not been answered for a certain period.
Item 2: PropertiesInformation on significant properties owned by the company.
Item 3: Legal ProceedingsLawsuits and other legal proceedings have to be reported in this section.
Do not ignore the litigation section. Even if it is from 10 years ago, keep an eye on it because it is included in there for a reason.
A lawsuit could be ongoing for more than a decade which will waste the company’s cash, time and other resources.
Item 4: Mine Safety DisclosuresOnly relevant for mining companies.
Part 2: Business Discussion and Financial Data
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesTalks about stock price and performance and how many shareholders they have. Only useful if you like to see the stock price highs and lows.
Item 6: Selected Financial DataIt’s a preview of the full financial statements.
Only the high level numbers are provided. Hence it is called “selected.”
To really get into the numbers and see what is going on, you need to skip to Part 4 where the full financial statements are displayed.
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis is the section where management will discuss what has been going on with the business, how it has been doing and may also discuss management’s view of key business risks and what it is doing to address them.
A must-read to pick the brains of the CEO and what the business direction is.
Is the content questionable? Is the CEO overly optimistic? Does he hide behind corporate mumbo jumbo?
Item 7A: Quantitative and Qualitative Disclosures about Market RiskThis is different from the risk section from Item 1A.
This section refers to risk related to market exposure, interest rates, foreign currency exchange rates, commodity prices and even stock price risk.
If a section has the word "risk" in it, be sure to read it.
Item 8: Financial Statements and Supplementary DataAudited financial statements are shown here or tells you which exhibit to look at towards the end of the document.
It’s the full financial statements, so it is definitely the most important section. Without knowing the numbers, how will you know what to invest in?
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial DisclosureThe title says it all.
This is where disagreements with the company accountants or changes in company accountants are disclosed. Any changes or disagreements with accountants is a big red flag which you must review.
This is a great place to dig up some dirt. Companies will try to hide the fact that they changed financial reporting policies.
Part 3: Insiders and Related Parties
Item 10: Directors, Executive Officers and Corporate GovernanceUsually asks you to open up the proxy document to find out more about the management team.
Things like how much they get paid, what perks they receive, who the involved parties are and lots of detail about management.
Item 11: Executive CompensationWant to see how much the CEO is making, what his performance targets are and other juicy details? You will be referred to the proxy document which you can find at the How to Read DEF14 Proxy guide.
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersSame as above.
Item 13: Certain Relationships and Related Transactions, and Director IndependenceA must-read in the proxy. It has information on whether the company is shifting money to family and insiders. You don’t want to see things like the company paying the CEO’s brother to provide consulting services on topics that you can get for free online.
Part 4: Full financial Statements and Footnotes
You would be crazy to skip this final part.
Some people read the 10-K backwards just for this.
Companies shove the juiciest information to the end of the document knowing that most people and analysts won’t make it to the end.
With your active reading skills, you can easily make it to the bottom of the document and discover information buried in the footnotes.
This section contains the financial statements again along with detailed breakdowns, definitions of what certain items mean to them, legal company documents with details such as a retention and incentive plan.
Practice, Practice, PracticeYou have to practice reading the 10-K.
Although I’ve tried to show you how to read the 10-K and what the sections mean, it can be difficult and time consuming.
But as you go through more annual reports, you will get into a rhythm and soon you will be breezing through the reports.
With the Internet these days, it is even easier.
If you use a free service like SEC filings, the 10-K is formatted so that you have access to links and menus to jump around the document quickly. If you read directly from the SEC, you will have to scroll through the entire document which can be overwhelming.