Are you wondering how to read a 10-K effectively? Warren Buffet is famed for being one of the world’s wealthiest men and the single most successful investor of the 20th century.
However, the one thing that always stands out is his ability to spend five to six hours a day reading. What’s more, 10-K reports top his list.
So how do you go about finding worthwhile investments? Perusing 10-K reports should be one of those items to check. At a glance, they can seem bulky, but knowing what to look for is a great start to learn how to read a 10-K.
What Is the 10-K Report?
A 10-K is an annual filing that public traded companies are required to submit to the U.S. Securities and Exchange Commission (SEC).
It offers a detailed picture of the company’s activities, subsidiaries, and the risks it faces, as well as the operating and financial results for the fiscal year.
The 10-K report has to be filed within 60 days after the end of the fiscal year. You can find a company’s 10-K report by using the SEC’S EDGAR database. But some companies post their 10-K reports on their websites.
Difference between an annual report and a 10-K
A 10-K has more detailed information than the annual report. An annual report is more for shareholders to view. It does have information related to the company and financial reports.
And while it is designed to report fiscal happenings, the main purpose is to encourage more investing.
The 10-K is an official report for the SEC in a standard format. It also has a letter from the CEO or chairperson and illustrations. Plus, it does have more information, but it isn’t designed to impress. It’s only meant to report, and it hits areas you won’t find in an annual report.
Some companies can file the 10-K as its annual report while others may provide both the 10-K report and an annual report to the SEC.
How to Read a 10-K: Breaking It All Down
To help you learn how to read a 10-K effectively, you have to understand that, as mentioned, these reports follow a strict format that’s determined by the SEC. It also helps to know how to spot financial monkey business, but that’s for another time.
All information is presented in 4 main categories that are broken down into 15 subheadings.
Let’s look at the four key areas that a 10-K report covers.
How to read a 10-K: company overview
An efficient way to tackle a 10-K report is by reading the business description. It provides a fundamental analysis of the company’s economic purpose, products or services, some sense of its history and the competitive conditions it operates in.
In this section, you’ll also find the risk factors, which involves an explanation about significant risks that apply to the company and its securities. The company should address the risks and not how it applies to them. Each risk is titled in bold, then its description follows.
This section also includes the unresolved staff comments where the company explains the comments received from the SEC staff on reports filed previously that have not yet been resolved.
A red flag most investors look for here is if the SEC has raised questions about the company’s unresolved statements.
The company overview section goes on to cover properties and legal proceedings that add to the overall picture.
How to read a 10-K: business discussion
In the business discussion, you’ll find out the company’s stock price and performance as well as the number of shareholders within the company. You will also read about certain financial information about the company for the last five years.
In addition, this is where you’ll read about the management discussion and analysis. Management provides the company’s perspective about business results for the past year.
You’ll also get to pick the brain of the current CEO and get a sense of the direction the business is going.
Information about the company’s operation and financial results are in this section. You will be able to find out its capital resources, liquidity, and how the company views its key business risks and what it’s doing to address these issues.
The disclosure about market risk here refers to risk related to interest rates, foreign currency exchange rates, commodity prices, market exposure, as well as stock price risk.
You’ll also get audited financial statements, exhibits, and disclosure about the disagreements, changes in company accountants and accounting procedures.
How to read a 10-K: involved parties
This section provides background information and experience of the company’s director and executive officers. It also offers insights into the company’s code of ethics and qualifications for its committees of the board.
You’ll also find a detailed discloses the company’s compensation policies and pay levels of the top executive officers. Similarly, you’ll get information about shares covered by equity compensation plans and whether each company director is independent.
This section also requires companies to disclose the number of fees they pay to their accounting firms for various tasks. Most companies provide a separate document for this step, called a proxy statement.
How to read a 10-K: full financial statements
This final section contains a list of financial statements and exhibits such as a list of the company’s subsidiaries, its bylaws, as well as legal company documents with retention details and incentive plans.
How to Read a 10-K: What to Look for in a 10-K Report
As you can see, the 10-K contains a wealth of information that makes it daunting to read. The good news is, you don’t have to read it word by word. In fact, smart investors just focus on some critical sections for red flags and skim the rest.
Wondering how to read a 10-K this way? Let’s look at the most valuable sections for your investment decision-making process.
Manager’s discussion and analysis (MD&A)
That’s where the company shares its side of the story on what happened the past year and its prospects.
If you noticed stalled sales or cash flow evaporating, the MD&A should explain this problem and shed light into what the company is doing to address the issues.
Look for whether any reported cash flow issues or risk factors will be permanent or temporary — or new. A red flag will be if the company keeps blaming external factors for its poor performance without taking an introspective look at its own shortcomings.
Public companies require an independent audit. So you’ll likely find an auditor’s report. Check whether the auditor agrees that the financial statements accurately reflect the position of the company and its accounting procedures.
Also, look to see if the auditor’s opinion is qualified or unqualified.
A qualified opinion reflects a better understanding of the company and it’s operations, as opposed to an unqualified opinion, which simply reports on whether they followed proper accounting principles.
You will find this section in the middle of part II of the 10-K report named “Financial Statements and Supplementary Data.” Any change or disagreement with the numbers should be considered an investing risk red zone.
Cash flow and other financial statements
The cash flow statement is where you get to understand the company a little better. The numbers literally speak real truth about the company. If the company can’t maintain its previous cash levels, it could mean two things.
You can find out that the company has reported massive income gains, but this will mean nothing if they can’t maintain it. Take note of how much the company is borrowing.
You should also look at the consolidated financial statements and discover any other risk factors.
For instance, the company could be getting half of its income from one or two key customers, and once these customers leave, this could take the company for a dive.
In short, look at all of the financial statements for multiple years and compare. Look for major changes and find out what they mean for the future of the company.
Debt to equity ratio
The debt to equity ratio reveals you how much debt and equity is being used to finance the company’s assets. To get this ratio, you divide the firm’s total liabilities by total shareholders equity.
The ratio also indicates how risky it is to invest in a company. The higher the ratio, the riskier the investment.
A good ratio is around 1 to 1.5, but the ideal debt to equity ratio varies by industry because capital-intensive industries such as manufacturing or finance. The ratio here tends to be higher than two.
When the debt to equity ratio is high, this indicates that the company uses debt to finance its growth. That means the business may not be able to produce enough money to repay its debts.
On the other hand, a low debt to equity ratio shows that the company hasn’t relied on borrowing to finance its operations. That may indicate the company is not realizing the potential profit it could gain by borrowing and increasing its operations.
But don’t stop there. Look at all of the company’s financial ratios for a complete investment picture.
As we mentioned earlier, the proxy statement accompanies the 10-K report. That’s where you find the character of the company. Does it operate under transparency and integrity?
You can find out whether the priorities of senior executives line up with shareholders. You can do that by looking at how much these executives have personally invested in the company.
Not only does the proxy statement highlight executives, but it can also show you litigation risks, detailed business plans, auditor changes, and clue you in on the health of the business you’re considering for investment.
And the “Certain Relationships” section will help you find any information about any conflicts of interest. That could be if a major customer or supplier also happens to be a relative of an executive.
Summing It All Up
You no longer have to wonder how to read a 10-K effectively. Practice the art of picking out relevant information for your investment decisions.
Focus on looking for discrepancies in auditing and proxy statements, cash flow, MD&A, and the debt to equity ratio to determine the company’s integrity and financial stability.
You can also check out 10-K reports that go back a few years to identify some patterns.
We hope this article has given you valuable insights on how to read a 10-K effectively in order to make better investment decisions.
If you have additional pointers, please share with us in the comments section below.