Key Things to Look at in an Annual Report When It Comes to Investing

Both personal finance author Jane Bryant Quinn and money columnist Matt Krantz recommend starting your annual report study with the footnotes like the pros do. These explanatory notes contain significant tidbits of information that cannot be explained in the financial statements. Maybe earnings fell because of an accounting change, for example. You could learn what debt must be refinanced or retired, if a windfall caused a spike in income and how various product lines or divisions contribute to sales.

Financial statements must reflect generally accepted accounting principles, or GAAP. An independent certified public accountant, or CPA, conducts an audit to verify that the company followed GAAP when preparing its financial statements. She also offers her professional opinion that the information is all-inclusive. An auditor's statement with no explanations signals that the numbers present a fair representation of the company's financial situation. Bryant advises investors to view the use of the term "subject to" in an auditor's statement as a warning flag and to note any inconsistencies or errors mentioned.

Footnotes give you an idea of what took place; this letter tells you why and expands on the year's events. Written by the president, CEO -- chief executive officer -- or chairman, this section also discusses goals, plans and the general state of the firm. Research by University of Nebraska faculty showed a correlation between CEO language style and company reputation. Look for simple writing that uses concrete words and few adjectives. The study found that buzzwords and complex sentences characterize poor-reputation firms. Words such as "except for" and "despite" also may signal trouble, according to Bryant.

The balance sheet presents the company's financial status as of the last day of its fiscal year: assets, liabilities and shareholders' equity -- what it owns, what it owes and what would be left if it sold everything and paid all of its debts. Current assets -- short-term investments, accounts receivable, inventories plus cash -- can be converted to cash within a year. Current liabilities -- debts due within 12 months -- include accounts payable, debt interest, dividends and taxes. Current assets minus current liabilities shows working capital, which indicates the ability to expand operations. Noncurrent assets include long-term investments, while noncurrent liabilities include long-term debt. To measure the company's ability to cover its debt, analysts add short- and long-term debt, then divide that total by shareholders' equity. This debt-equity ratio, when less than one, tells them that shareholders have a larger stake in the firm than its creditors.

The income statement tells you whether the company made or lost money. Did revenue, or sales, rise or fall? Remember that the footnotes and shareholders' letter explained why. Maybe they entered a new market or introduced a new product and increased sales, or sold part of the business causing sales to drop. You also can refer to the footnotes to understand any write-offs or restructuring charges listed under other operating expenses. Dividing operating income, or EBIT -- earnings before interest and tax -- by the interest expense will show the company's ability to pay its debt, or interest ratio. The higher the ratio, the better.

The statement of cash flows tells the amount of cash that came into the company and how much it spent during the year. You want to look at "cash flow from operating activities." This important number shows the ability to generate cash from core operations, rather than from investments or selling off assets. "Cash flow from operating activities" minus capital expenditures, listed under "cash flows from investing activities," equals free cash flow. Free cash flow is extra cash available to increase dividends or invest in the business without affecting operations. Consider cash flow and other financial measurements in the context of the company's industry. A service business with low investment needs tends to have a high cash flow compared to a manufacturer.