The Truth of Credit

photo by holzworthlynn

Well, it’s spring time and most publicly traded companies are issuing their Annual Reports to their Shareholders. For the casual investor, this is the absolute minimum diligence you need to do when researching a stock. An Annual Report is simply a summary of how the company performed over the past year. The report should consist of nine items:

1. Chairman of the Board Letter – This should cover any changing conditions, future goals to achieve, actions taken or not to be taken.
2. Sales and Marketing – This should cover what the company sells:  The how, where and when.
3. 10 Year Summary of Financial Figures – Hopefully your company is making money.
4. Management Discussion and Analysis – This is a discussion of significant financial trends.
5. CPA Opinion Letter - Written by the CPA firm (KPMG, Ernst & Young, etc…), this is an opinion on the company’s financial statements.
6. Financial Statements – These show the sales, profits, R&D spending, inventory and debt levels over time.
7. Subsidiaries, Brands and Addresses – This will list any brand names the company has and any overseas distributors.
8. List of Directors and Officers - Tip: Make sure your these people have a big stake in the company.
9. Stock Price History – Shows the general trend of the stock price over time.

For the most part, it is highly recommended that you read the full document, but here are some tips to help you with the important stuff:

• The first thing you should do is flip toward the back of the report and locate a page titled, “REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM”.  If the annual report does NOT contain this section, throw it away and avoid investing in the company. A reputable accounting firm is necessary to prevent Enron-type disasters.

• Balance Sheet - Obviously you would like the bottom line going in a positive direction. One item you should be interested in is what exactly makes up the mix of assets. If a large part of the company’s assets where acquired from previous years then the company may not being doing as well as it seems.

• Income Statement -If you take the net income and divide into it the number of outstanding shares the company has, you will get Earning Per Share (EPS), a common test investors use to determine the worth of a company. A smart way to judge a company is to compare its EPS against competitors in the same industry. This can easily be done using a website like Yahoo Finance.

• Cash Flow Statement – Ideally, you want to see that they can pay for their Investing activities with their Operating activities. Having to use Debt to stay afloat is a losing proposition for an established company and a bad sign for investing.

• Footnotes -These are often a more revealing part of the report. Think danger if you see: Changes in accounting methods or inventory valuation, new or changed government regulations, debt realignment, litigation results or forecasts and any unusual events. Most of all, if something is not clear you need to ask questions. Companies are notorious for filling their footnotes with important information with vague choice words.

Investing is more of an art than a science. As a investing artist, you must know the basics, and being able to read financial statements is a great place to begin. If you want to learn from from the master, my suggestion is to read Berkshire Hathaway’s Annual Reports.  Warren Buffett’s insight into his own companies is a must read for any wannabe investor.