By Joshua Kennon. Investing for Beginners Expert
Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.
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It is full of the nitty-gritty details that make a lot of people’s eyes glaze over and, unfortunately, there is no way to simplify it. Once you’ve read a few 10K's, they will begin to look more and more accessible because they typically follow the same pattern.
There are many required parts of a 10K, including:
- An explanation of a company’s operations, how it makes its money, and the markets in which it currently operates. This explanation lets you understand the business. You’ll be surprised by some of the things you find. One of the greatest investments of the 1990’s was a mutual fund company called Janus that began as a tiny subsidiary of a railroad. Shareholders who went through the 10K and found that this little money management unit was doing spectacularly made enough money to retire in just a few short years.
- Disclosures of risks the company faces, including current lawsuits. In my time, I’ve actually come across companies that otherwise looked very healthy but were facing the prospect of bankruptcy due to huge pending lawsuits that threatened to take down the whole firm. Famous cases include the asbestos trials several decades ago when businesses that were only vaguely related to construction were sued and forced into liquidation or reorganization, wiping out the stockholders. You definitely want to take time to read these risk disclosures.
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- The financial statements such as the income statement and balance sheet that show you how much money a company made, its debt levels, and other important data. The financial statements are the most important part of the 10K because they allow you to see what is going on with the company’s finances. The process of reading these financial statements is not as difficult as it sounds, but there are dozens of pitfalls that you should be looking for as you read the 10K. Discussing those here is far beyond the scope of this article, but if
you read Investing Lesson 3 – How to Read a Balance Sheet and Investing Lesson 4 – Income Statement Analysis. I will spend more than one hundred pages walking you through the process line-by-line. Print those specials and over the next few weeks, work your way through them. It will take you far less time than taking an accounting course at a local college but by the time you’re done, you will be years ahead of your friends and family in understanding how stocks and bonds work .
- Operating leases that don’t count as debt on the balance sheet. There are many forms of debt that can make a company go bankrupt that do not show up on the balance sheet due to accounting rules but the law requires the payments be disclosed in the 10K. For instance, if you owned a small clothing boutique at the local mall and had no debt but paid $10,000 per month in rent to the mall owner, according to GAAP rules (those are the guidelines that determine how the finances must be disclosed), you may end up showing little or no debt. If sales fall and you stop sending checks to the landlord, the mall owner can obviously kick you out of your storefront and force your company into bankruptcy due to the missed lease payment. Every 10K will include a section that discusses “fixed payments” or “operating leases ” or “minimum cash payments due”. Find it. Read it. Know it.
- The company’s accounting policies. Imagine that you are considering buying stock in a washing machine manufacturer. This company suddenly is in the news because a lot of models are breaking down beyond repair. Is the company on the hook for taking them back from customers? In the 10K, a company has to disclose its warranty policies and estimated warranty costs for products it sells or manufactures.
- The CEO's and CFO’s signed letters stating the books are accurate to their knowledge. These letters were made a requirement after the accounting frauds following the dot-com bust when Worldcom and Enron dominated the headlines. They are a way for the government to prosecute executives that knowingly falsify their accounting records .
In a nutshell, those are the important parts of a 10K. Learning to read one is sort of like swimming. At some point, you just have to jump in the pool and get wet. You don't have to start doing Olympic-quality dives, so feel no pressure to jump into advanced pension accounting. Instead, just flip through the pages and read what you do understand. Learning to invest is a process and everyone starts somewhere. There was a point in time when even I had absolutely no idea what those numbers meant. You will learn, if you are willing to put in the work.
Some useful additional information: A 10Q is a smaller version of the 10K that is filed at the end of each business quarter with the SEC.
For more information, check out our financial statement guide for new investors.