WARNING SIGNS: When a President’s letter says the company experienced “a challenging year” that means a decline in sales and profits. If the letter mention challenges ahead, ask yourself if this is just go-getter talk or if there are there real obstacles on the horizon. Terms like “despite the” and “except for” should raise red flags to problem areas.

Other things to look out for include apologies. Are they making excuses for the lack of progress in some area? Are they playing the blame game, by citing the economy or some other trend? Or do they take responsibility for their actions? If they are open and truthful about the problems it is better than if they try to gloss over them. They get points for honesty especially if they have a track record of surmounting roadblocks.

Sales and Marketing
How are things selling? In what markets, and to which major customers are they making sales? Is there a seasonal cycle or is there a trend that clusters sales? Which products are most popular? If there is only one product line, does the demand for that one product look good long term? If there are many divisions or product lines, is it clear how each is selling? What’s the trend over the last five years? Is the rate of sales increasing over the rate of inflation? If you’re looking at the annual report in order to evaluate a company for potential employment, high growth companies with a 15+% sales increase each year will probably promote employees quickly. Sales may have slowed temporarily if the company is expanding into new markets. In this case a short term slump might be good for the company’s long term prospects.

10 Year Summary of Financial Figures
(In some cases this section only goes back five years.) Decide if the company has experienced steady growth. Note the up and down years; very rarely do companies fall apart or zoom to the top of the heap at once. Success and failure are usually part of a trend. Focus on the last five years. Have the profits and operating income grown? Look for the column that says “Earnings per Share.” If they are declining or inconsistent, you should be concerned. If earnings are rising, things are looking good.

Management Discussion and Analysis
This is where the management team goes over the financials and explains what has been happening over the past two years. Does it seem truthful and accurate?

CPA Opinion Letter
Securities regulations require an outside Certified Public Accountancy firm to give its opinion of the financials. Look at their qualifications. If they came from “Bob’s School of Accounting, Beauty and Alligator Wrestling,” you might want to give the numbers a closer look. Either in the letter or in the footnotes of the Financial Statement, the CPA must report changes, problems, deviations and any other strange happenings. 

See if there are any changes in accounting methods from the previous year. A change in accounting practices could suddenly give a depressed company increased “earnings.” Pay attention to any accounting change that relates to how they measure or value inventory. Lots of idle inventory is bad. Some accountants can make it disappear with the stroke of a pen. 

Also keep a look out for new or changed government regulations, debt realignment, litigation results, forecasts, UFO abductions, etc. If any number is said to be “subject to” something, that means that there is currently a company initiative that may affect the number. Look closely at that number because it may be “subject to a miracle happening.”

Financial Statements
Check out earnings per share. If this figure trends up, life is good. Just be sure to check out the source of those earnings. Sometimes earnings happen for one time items like the sale of a business or an accounting change. (To double check, compare revenue from regular operations and expenses.) Be vigilant because gross earnings can increase but profits can drop if expenses keep rising. Whip out the calculator and divide the net income by the gross sales to figure out what part of each dollar of sales results in profits. If this figure is even or upward, the company is on the level. If the figure is going down while earnings are up, an accountant is playing reindeer games.

Check to see if inventories are increasing faster than sales. That means that they are making more product than they can sell. A large inventory means customers are no longer buying.

If receivables are increasing faster than sales, that means that they aren’t collecting their bills on time. This is also a danger sign. 

What are the debt levels over the year? Have they changed? Why? Check out the debt-to-equity ratio. To determine long term debt, divide the long term liabilities by the stockholder’s equity. If the number is less than 50%, that’s good. For short term debt, current liabilities should be less than 50% of assets. This number tells you how much of a cushion the company has in case all the creditors come knocking. You want working capital (current assets minus current liabilities) to be trending up. If it is trending down, that could signal a problem.

Be sure to read every footnote. That’s often where you find little nuggets that expose abnormalities in the numbers. Be sure you are seeing the whole picture not a “selection of certain assets.” With every footnote, ask yourself this simple question: does this note tend to inflate revenues or minimize expenses?

Subsidiaries, Brands and Addresses
Is it clear what the structure of the company is? Is it clear which lines are the most profitable? Do they have overseas operations and/or distribution?

List of Directors and Officers
How many are outside vs. inside? Are they well known and respected? How many are family members? How many are there? Too few (less than 5) and they probably won’t have a diversity of opinion. Too many (more than 12) and they probably have a hard time getting anything done.

Stock Price History
This will tell you how the stock has performed over time. What is the bonus/dividend history? You’ll also learn a few things that will make it easier for you to buy the stock like which stock exchange it is listed on and what its symbol is.