Reading Financial Reports for Dummies (15 page)

An increase in the allowance for doubtful accounts may indicate a problem with collections or be a sign of significant problems in the industry as a whole.

The discussion in this section of the annual report can get very technical. If you find things you don’t understand, you can always make a call to the investor relations department to ask for clarification. Whenever you’re considering a major investment in a company’s stock, be certain that you understand the key points being discussed in the MD&A. Anytime you find the information beyond your comprehension, don’t hesitate to research further and ask a lot of questions before investing in the stock.

In the MD&A, managers focus on three key areas: company operations, capital resources, and liquidity.

Chapter 5: Exploring the Anatomy of an Annual Report
67

Company operations

Management commentary on this topic focuses on the income generated by, and expenses related to, the company’s operations. To get some idea of how well the company may perform in the future, look for

✓

Discussion about whether sales increased or decreased

✓

Details about how well the company’s various product lines performed

✓

Explanations of economic or market conditions that may have impacted the company’s performance

The MD&A section also discusses

✓

Distribution systems:
How products are distributed.

✓

Product improvements:
Changes to products that improve their performance or appearance.

✓

Manufacturing capacity:
The number of manufacturing plants and their production capability. The MD&A also mentions the percentage of the company’s manufacturing capacity that it’s using. For example, if the firm uses only 50 percent of its manufacturing capacity, that may be an indication that it has lots of extra resources that are idle. If the company is using 100 percent of its manufacturing capacity, that may indicate that it has maxed out its resources and may need to expand.

✓

Research and development projects:
The research or development the business is doing to develop new products or improve current products.

The manager also comments on key profit results and how they may differ from the previous year’s projections. You should also look for cost information related to product manufacturing or purchase. Cost-control problems can mean that future results may not be as good as the current year’s, especially if management mentions that the cost of raw materials isn’t stable.

Look for statements about interest expenses, major competition, inflation, or other factors that may impact the success of future operations.

Capital resources

A company’s
capital resources
are its assets and its ability to fund its operations for the long term
.
In addition to a statement that the company is in a strong financial position, you find discussions about

✓

Acquisitions or major expansion plans

✓

Any major capital expenses carried out over the past year or planned in future years

68
Part II: Checking Out the Big Show: Annual Reports

✓

Company debt

✓

Plans the company may have for taking on new debt

✓

Other key points about the company’s cash flow

Liquidity

A company’s
liquidity
is its cash position and its ability to pay its bills on a short-term or day-to-day basis. I cover how to analyze liquidity in Chapters 12, 15, and 16.

Bringing the auditors’ answers to light

Any publicly traded company must provide financial reports that have been audited by outside auditors. (I talk more about the audit process in Chapter 18.) You usually find the
auditors’ report
(a letter from the auditors to the company’s board of directors and shareholders) before the financial information or immediately following it.

Before you read the financial statements or the notes to the financial statements, be sure that you’ve read the auditors’ report. You read the auditors’

report first to find out whether the auditor raised any red flags about the company’s financial results and what those questions are. But you won’t find answers to these questions in the auditors’ report. To find the details, you need to read the MD&A, financial statements, and the notes to the financial statements. But if you haven’t read the auditors’ report first, you could over-look some critical details.

To lend credibility to management’s assurances, companies call in independent auditors from an outside accounting firm to audit their internal controls and financial statements. Auditors don’t check every transaction, so their reports don’t provide you 100 percent assurance that the financial statements don’t include misstatements about the company’s assets and liabilities. Auditors don’t endorse the company’s financial position or give indications about whether the company is a good investment.

Most standard auditors’ reports include these three paragraphs:

✓

Introductory paragraph:
Here you find information about the time period that the audit covers and who’s responsible for the financial statements. In most cases, this paragraph states that management is responsible for the financial statements and that the auditors only express an opinion about the financial statements based on their audit.

Essentially, this is a “protect-your-fanny” paragraph where the auditors attempt to limit their responsibility for possible inaccuracies.

Chapter 5: Exploring the Anatomy of an Annual Report
69

✓

Scope paragraph:
In this paragraph, the auditors describe how they carried out the audit, including a statement that they used the
generally
accepted audit standards.
These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatements. A
material misstatement
is an error that significantly impacts the company’s financial position, such as reporting revenue before it’s actually earned.

✓

Opinion paragraph:
Here the auditors state their opinion of the financial statements. If the auditors don’t find any problems with the statements, they simply say that these statements are prepared “in conformity with generally accepted accounting principles” (or GAAP). For more on GAAP, see Chapter 2.

When an auditors’ report follows the outline I describe here, it’s called a
standard auditors’ report.
And because no qualifiers (or red flags) limit the auditors’ opinions, it’s also an
unqualified audit report.

If the auditors find a problem, the report is a
nonstandard auditors’ report.
In a nonstandard report, auditors must explain their opinions in a
qualified audit
report
— in other words, they qualify their opinions and note problem areas.

(I discuss possible problems auditors may encounter later in this section.) A nonstandard auditors’ report and a standard auditors’ report have the same structure; the only difference is that the nonstandard report includes information about the problems the auditors found.

When you see a nonstandard auditors’ report, be sure that you find a discussion of the problems in the MD&A and in the notes to the financial statements.

Also, when reading the MD&A, be certain that you understand how management is handling the problems noted by the auditors and how these problems may impact the company’s long-term financial prospects before you invest your hard-earned dollars. (Call the investor relations department to ask for clarification, if you need to.) If you’ve already invested, look carefully at the issues to be sure you want to continue holding your stock in the company.

A nonstandard auditors’ report may include paragraphs that discuss problems that the auditors found, such as the following:

✓

Work performed by a different auditor:
In many cases, this isn’t a major problem. Maybe a different auditor handled the audit in previous years or audited a subsidiary of a newly acquired company. But whenever a company changes auditors, you need to know why it made the change, and you should research the issue. You probably won’t find the reason for the change in the annual report, so you may have to research the change in news reports or analysts’ reports. Because changing auditors can negatively impact a firm’s stock price, companies are usually 70
Part II: Checking Out the Big Show: Annual Reports
very careful about changing auditors. Wall Street typically gets concerned whenever a change of auditors occurs because it can be a sign of a major accounting problem that hasn’t surfaced yet.

✓

Accounting policy changes:
If a company decides to change its accounting policies or how it applies an accounting method, the auditors must note the change in a nonstandard auditors’ report. These changes may not indicate a problem, and if the auditors agree that the company had a good reason for making the change, you most likely have no reason for concern. For example, if the company changed how it reported an asset because that change is required by the SEC, that’s a good reason for making the change.

If the auditors disagree with the company’s decision to change accounting methods, they question the change and provide a
qualified opinion
(which I discuss later in this section) in the nonstandard auditors’

report. If their report indicates a change in accounting policy, be sure to look in the notes portion of the annual report for the full explanation of the change and how it could impact the financial statements. When companies change an accounting policy or method, the change impacts your ability to compare the previous year’s results to the current year’s.

✓

Material uncertainties:
If the auditors find an area of uncertainty, it’s impossible for management or the auditors to determine the potential financial consequences of an event. Uncertainties may include debt-agreement violations, damages the company must pay if it loses a pending lawsuit, or the loss of a major customer or market share. If the auditors believe that these material uncertainties could impact future earnings, they’ll include a paragraph about the uncertainty and give a qualified opinion.

If a loss is probable and the auditors can estimate it, the financial statements usually reflect this loss, and the auditors give an unqualified opinion. So in reality, the impact of a known loss can be a greater problem than a possible loss where the consequences are unknown. The company and the auditors have a responsibility to make you aware of the uncertainty so you can factor that into any decisions you make about your potential dealings with, or investment in, the company.

✓

Going-concern problems:
If the auditors have substantial doubt that the company has the ability to stay in business, they’ll indicate that the company has a
going-concern problem.
Problems that can lead to this type of paragraph in the auditors’ report include ongoing losses, capital deficiencies, or a significant contract dispute. If you see a statement by the auditors that the company has a going-concern problem, it’s a major red flag and a good indication that you shouldn’t invest in this company.

✓

Specific disclosures:
Sometimes auditors indicate concerns about a specific financial matter but still give the company a nonqualified opinion. Many times the auditor believes that these are matters the public
Chapter 5: Exploring the Anatomy of an Annual Report
71

should know about but aren’t signs of a serious problem. For example, if the company is doing business with another company that has officers involved in both firms, the auditor may note this issue in a special paragraph. The notes to the financial statements explain any specific disclosure in greater detail.

✓

Qualified opinions:
Any time the auditors issue a nonstandard report, they also issue a qualified opinion in the final paragraph of the report. A qualified opinion doesn’t always mean that you should be alarmed, but it does mean that you should do additional research to make sure you understand the qualification. Sometimes a qualified opinion may simply indicate that the auditors didn’t have sufficient information available at the time of the audit to determine whether the issue raised will have a significant financial impact on the company. You should look in the notes to the financial statements or the MD&A for any explanation of the matter that caused the auditors to issue a qualified opinion.

Presenting the Financial Picture

The main course of any annual report is the financial statements. In this part, you find out what the company owns, what the company owes, how much revenue it took in, what expenses it paid out, and how much profit it made or how much it lost. I cover each of the following statements in great detail throughout the book, so I mention them briefly here and indicate in which chapters you can find additional information.

When looking at a company’s financial results, make sure that you’re comparing periods of similar length or a similar collection of months. For example, a retail store usually has much better results in the last quarter of the year (from October to December) because of the holiday season than it does in the first quarter (from January to March). Comparing these two quarters doesn’t make sense when you’re trying to determine how well a business is doing. To judge a retail company’s growth prospects, compare the fourth quarter of one year with the fourth quarter of another year. I talk more about income statements in Chapter 7 and tell you how to analyze these statements in Part III.

✓

Balance sheet:
Also known as the
statement of
financial position,
this document gives a snapshot of a company’s assets and liabilities at a specific point in time. I discuss all the parts of the balance sheet in Chapter 6, and I talk about analyzing the financial reports in Part III.

✓

Income statement:
Also known as the
profit and loss statement
or
P&L