Top Things to Watch Out for When Reading Financial Reports

Apologies for Shortfalls

A corporation’s annual report offers the board of directors the opportunity to strut their stuff and summarize the past year. They also get to use the report to show their strategies for the coming year. So if you’re reading the report and come across an apology (veiled or outright) in the chairman’s letter that a particularly lofty goal wasn’t quite met because of unforeseen events, you want to investigate further to see just how far the goal was missed by and how unlikely the event in question may have been. If missing the goal has a significant impact on the future of the company, then you need to keep an eye on future developments.

Blurring in the Overall Picture

A company is most happy to report record revenues and successfully-met sales goals, but is the annual report clear on where that income is being generated? How and where is the revenue coming from during the year? Are the different divisions that make up the company clearly defined? It’s fine that revenue is coming in, but you want to know where the revenue is coming from and if the result can be replicated.

Wishy-Washy Descriptions of Trends

The management of a company uses various records to determine the financial situation both past and present. So you should be able to find documentation concerning the financial trends of the company — whether the financials are good news or bad news. And that documentation should be written in a clear and honest discourse. If the report is wishy-washy and uninformative, it’s your job to find out more. You don’t want vague generalities about the finances; you want cold, hard facts.

An Overabundance of Footnotes

Footnotes are designed to clarify information in a financial report. Beware of an overabundance of footnotes or of vague references in footnotes. Why? Because a report is meant to be informative and instructive. Footnotes are extra bits of information or clarification and shouldn’t contain the meat of the report. And remember that any time information is pulled away from the body of a report, you have an interruption of the flow of material. This interruption isn’t good because it impedes your ability to understand the report and see the whole picture.

Listings of the Directors

You’ll find a listing of the board of directors in a company’s annual report. Determine how many directors are on the board. Do you really think that the number of directors currently on the board is enough? Or do you think that there are too many? You also may want to read through the directors’ brief biographies so you can get an idea of who’s sitting on the board and what their agendas may be. By looking at their histories, do you think that the directors represent a wide range of experience and corporate responsibility, or are they all apparent buddies of the president? A wide range of experience provides a more global perspective — not everyone is looking at the company with the same preparation and background. Buddies of the president may be more forgiving of errors and missteps; you want directors who are more objective.

A High Working Capital

When reading a company’s cash flow statement, be wary of especially large amounts of working capital (money just sitting there — items produced and warehoused but not sold). A big number in the working capital entry may mean that inventory isn’t being moved out as quickly as it should be. And if inventory isn’t moving out at an appropriate rate, then sales are probably stagnating, and that will affect revenue in the future.

Long-Term Debt

Many companies use loans to help their businesses grow. And why not? Borrowing makes good business sense as long as the amount is reasonable and the projected payback is doable. Having said that, beware of a company with a large amount of long-term debt. Having to pay interest on long-term debt tends to cut into a company’s cash flow.

Last word

financial reports are full of numbers, and unfortunately, numbers can lie. In Chapter 8, for example, I show you how to lie with statistics. (Okay, I don’t show you how to actually lie, but I do show you how it can be done.) Numbers can be slippery fellows, but so can words. So watch for the hidden meanings when you see words and phrases like challenging, undertaking corrective measures, adjustments, and significant difficulties.

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