Newspapers usually run a summary of the annual reports of industries and businesses in their readership area. Readers want to know the economic health of the companies that employ local people, and some may own stock is these firms. Many readers also want to know about the status of the firms that have large numbers of shares of stock distributed nationwide—IBM, Kodak, General Motors, Polaroid, AT&T, Ford, General Electric. These readers may be shareholders—more than half the adult population owns stock—or they may be planning to invest in stocks. Or a part or all of their retirement benefits may be tied to stocks. The business reporter must be able to swim through a sea of figures toward the few pieces of essential information in the report.

What to Look For

First, read the auditor's report, which is usually at the back. "Generally, if the auditor's report is two paragraphs long, the financial statements have been given a clean bill of health," says the American Institute of Certified Public Accountants. "Anything longer—an extra paragraph or so—and normally that's a red flag alerting you to look further."

Jane Bryant Quinn, CBS business commentator, says the words "subject to" in the auditor's report are a warning signal.

"They mean the financial report is clean only if you take the company's word about a particular piece of business, and the accountant isn't sure you should," she says.

The CPA Institute has a general caution about the auditor's report: "All it means is that the financial statements are fairly presented in conformity with generally accepted accounting principles." It doesn't mean that the company is in great financial shape, or even in adequate condition. All it means is that the books are kept properly.

A number of suits have been filed against major auditing firms for failing to catch slippery entries in the books. The SEC has tightened up its requirements for auditors as a result of a number of businesses failing despite approval from the auditors.

Next, skim through the footnotes, says Quinn. Sometimes they explain the figures that seem surprising, even alarming. Earnings might be down. But the footnote may explain that the company has applied a policy of accelerated depreciation on plants and other equipment. "This could reduce earnings, while a slower depreciation rate could boost earnings," says the CPA Institute.

Next, look at the letter from the chairman or the president's report in front of the annual report. It usually is frank—if it adheres to the standards set by the CPA Institute. Usually, the statement is a candid summary of the past year and of prospects.

The Figures

The figure in which most people are interested is earnings per share, also called net income per common share. (See Table 23.1.) This is the bottom line, a sign of the company's health. It is, in effect, the profit the company has made. It is computed by dividing the total earnings by the number of shares outstanding. The CPA Institute says that slight year-to-year changes can be ignored. Look for the trend in the 5- and 10-year summaries. "If the EPS either remains unchanged or drops off, this may pinpoint trouble ahead," it says.

Look at the record of dividends as well as the current dividend. Is there a trend? Here is a five-year period of dividends of NRW Enterprises:

This firm shows a steady climb in dividends over the past five years. However, the business reporter will note that although the 2006 dividend is larger than the previous year's dividend, the company's net income per share on continuing operations is down, from $3.27 to $3.01. (See Table 23.1) In other words, the company plowed less of its earnings back into the firm in 2006 than it did in 2005, in order to keep the dividends on an upward course.

Be careful about earnings per share. A sudden increase can come from selling a plant or cutting advertising or research, says Quinn. The footnotes will explain unusual increases if they have unusual causes. A sudden decrease can come from an increase in the number of shares, a stock split or a new issue, which is also noted in the report.

Next, look for the figures on working capital. "This is regarded as an important index of a company's condition, because it reports whether operations generate enough cash to meet payroll, buy raw materials and conduct all the other essential day-to-day operations of the company," says the CPA Institute. After all the expenses have been met, the company uses part of its net income to pay dividends. These are paid from net working capital, and if this figure (net working capital) shrinks consistently from year to year, even quarter to quarter, it is a sign the company may "not be able to keep dividends growing rapidly," says Quinn.

For further information about how to read an annual report, write the CPA Institute, 1211 Avenue of the Americas, New York City, NY 10036, and ask for the booklet "What Else Can Financial Statements Tell You?"