Annual Reports: Form 10-K

What It Is

Think of the 10-k as a firm’s official annual report. It’s more thorough than the glossy reports companies send to shareholders, which are exercises in marketing as much as disclosure. The form, which firms that have a publicly held market value of more than $700 million must file within 60 days of the end of their fiscal year, provides the most comprehensive overview of a business and its performance during the past year. (Smaller companies have a bit longer to file.)

The 10-k is divided into three parts:

• Part I includes an overview of the business, the risks it faces and the properties it owns.
• Part II contains financial results for the year and management’s discussion of them.
• Part III identifies the firm’s directors and large investors.

What to Look For

The 10-k can run to over 200 pages, much of it boilerplate or legal mumbo-jumbo you can skip. Here’s where you’ll find the most useful material, in order of appearance:

Business overview explains how the company makes money. “You need to read this section,” says Larson. “It may well surprise you. You probably think Exxon explores for oil—but read the business overview in its 10-k and you’ll find that it’s mostly in the refining and chemical business.”

Management’s discussion of results. Firms use this space to discuss the past year’s successes and failures. “This is as good a place as any to get a sense of management’s attitude toward shareholders,” says Larson. “Do they view shareholders as minority partners, or as a nuisance?”

Look for this section to be clear, comprehensible and concise rather than wordy and obscure. Larson recalls covering independent power company Calpine soon before it declared bankruptcy. “It had a 10-k as thick as a phone book,” he says. “I used to put it on my desk next to Exxon’s report as a joke. I’d say to my colleagues, ‘Guess which is the largest company in the world, and which is the junky power company that’s about to go bankrupt.”

Changes in and disagreements with accountants on accounting and financial disclosure. This section offers information on independent auditors’ findings about a firm’s accounting procedures and past reports. Reading may help you decide how much faith to put in the company’s numbers.

AIG’s 2004 10-k reported that former top executives appeared to have pushed overridden company accountants to and used questionable methods for reporting profits in derivatives trading, among other things. The audit foreshadowed the stock’s 2008 collapse, which resulted from the company’s shadowy derivatives business.

Financial statements, including a complete income statement, balance sheet and statement of cash flows. “These are by far the most important pages of any 10-k,” says Larson. “They’re the report card for the year.”

Use this section to look beyond earnings. Everyone knew that 2008 would be rough on homebuilder Toll Brothers and the rest of its industry. Indeed, the firm’s net income plummeted to a loss of almost $300 million, down from a $687 million profit two years before. But Toll Brothers’ statements contained at least some reason for optimism: The firm ended the year with more than $1.6 billion in cash, up from $900 million at the end of 2007—perhaps positioning the company to take advantage of an eventual recovery.

Explanation of accounting policies. This section is as dry as it sounds, and most of the information is useless—but don’t skip it: “It includes a lot of unimportant stuff, with a few very important things scattered through it,” says Larson.

Here you’ll find explanations of issues that have nothing to do with how well a company’s products sell, but everything to do with its viability. Say you’re looking into an old-line industrial firm with a big pension plan. The company will project whether the plan is adequately funded, based on its assumptions for market returns, health care costs and other factors.

Make sure that such assumptions look reasonable—and take note of the potential impact if they prove to be wrong. Larson uses General Motors as an example. “Before GM went through the government washing machine, the company’s pension was so huge that selling cars was incidental. The stock was basically a bet that U.S. health care costs would stay low and stocks would rise,” he says. “Things didn’t work out that way.”