How to read a 10-K filing: a basic guide

The poll I ran a while ago on 10-Ks didn’t get many takers, but I decided this might be a useful enough topic to write about anyway. It turns out, I think, that unless they’ve had a business school education or worked in finance, most people find 10-Ks intimidating, boring, and unappealingly long documents. That might seem to be the case, but they’re chock full of information on a company and well worth reading before choosing to invest money in the company’s stock. Even if you don’t know what all of the terminology means, or how to calculate financial ratios, you can get a good idea of what the company does, what risks there might be to its operations, and what plans management have in mind.

What are 10-Ks?
10-Ks are documents that the SEC requires that each and every publicly-traded company file at the end of their fiscal year. They’re also sometimes called annual reports, though I tend to think of these as the nice fancy books that come with the 10-Ks that the company mails out each year that do more highlighting and marketing of the company than anything else. Companies are required to mail you these documents (physically or, sometimes, electronically) if you own even one share of their stock, but if you’re looking at potential companies to invest in, you’ll find these easily accessible at either EDGAR or the company’s own website. Yahoo! Financials also links to a company’s most recent SEC filings, and their interface is a little easier to use and read.

How to read ’em
10-Ks are pretty much all presented in the same format. On the first page, the name of the company, the period that the 10-K is covering, and the number of shares outstanding are listed. Then the table of contents, which are itemized. We’ll go through these and cover the most important and basic parts to read.

Item 1: Business

This section introduces the reader to the company, its business, and industry. It’s an important section to read if you’re thinking about investing in a stock, as it will outline the history of the company, any recent developments, and give an overview of the industry and its competitors as well. It’s a good way to determine not only whether the company has a good plan, but to take into consideration what macroeconomic factors impact the company’s industry positively or negatively. 10-Qs (quarterly reports) will contain an abbreviated version of this, so to get the most information on a company, it’s best to start with its 10-K.

Item 3: Legal Proceedings

If you’re thinking of investing in a company, you’ll want to know if it’s currently under any serious litigation. For this information, I usually go to the Financial Notes section of the document, but it’s good to skim through this area to see if anything significant jumps out. Keep in mind that it’s not unusual for companies to face multiple lawsuits, most of which will either be dismissed or not have a significant impact on the company. The SEC requires companies to disclose their estimated liability amounts if they face an adverse ruling if they feel that outcome is likely or the amount is significant.

Item 7: Management’s Discussion and Analysis

Also known as the MD&A, this is one of the key parts of the 10-K and well worth reading if you read nothing else. Here, management discusses and compares past and present results, and what they expect for the future. For example, costs and revenues might have changed since last period. If so, what drove those changes, and do they expect more? Some of the information from Item 1 is repeated here, but again, if you’re completely new to the company, you may be lost reading the MD&A without some background from Item 1 about the company and industry. If you understand them, any accounting policy changes are also discussed in this section.

Somewhere in the MD&A, usually toward the end, will be a section called “Liquidity and Capital Resources”. It should discuss how management plans to raise money for its future plans. For example, if the company plans on acquiring other companies or opening new plants, do they have sufficient funding to do so? If not, are they planning on issuing more debt? Or selling more shares of stock? How strong is their financial position?

Item 7A is also where risk factors to their business are disclosed. For example, do the bulk of their revenues come from only a handful of customers? What are key macroeconomic factors that might cause a downturn in their industry or company? Are they in a highly regulated industry? The SEC requires companies to reveal these risks, and they’re important to take into account. However, and this is true especially if you’re evaluating small companies because there are usually many items listed, reading this list over and over again may convince you that no company out there is worth investing in.

Item 8: Financial Statements

Here you will find the company’s Income Statement, Balance Sheet, and Cash Flow Statement, or information on where they are located in the document. These three financial statements comprise the bulk of information on how the company has performed, and an understanding of accounting and financial ratios can give you a lot of information. Motley Fool, Investopedia, and several other sources explain how to calculate financial ratios, and a basic how-to guide from the SEC for beginning investors is also available.

Somewhere in this section will also be a letter from the company’s auditors certifying that the financial statements are sound and nothing out-of-the-ordinary was found. Supposedly each auditor has its own set format for this letter (e.g. 3 paragraphs), and if there’s more than that, it’s worth reading the letter and the Notes to the financial statements, because chances are a change in accounting policies or something else unusual occurred.

One part of Item 8 that shouldn’t be ignored are the Notes to Consolidated Financial Statements that come after the financial statements themselves. This is where you’ll find revenue and expense recognition policies (historically, two areas where companies have sometimes used inappropriate ways to improve their financials), as well as disclosures and discussions on other line items in the financial statements, such as how inventory is recognized. The part about litigations that I mentioned earlier can be found in the “Contingencies” section of the Notes as well. In truth, the Notes section deserve reading with a fine-toothed comb, but unfortunately it’s out of the scope of this basic how-to guide.

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