How to Read the Footnotes in Annual Financial Reports
Reading the footnotes in annual financial reports is no walk in the park for accountants. The investment pros read them because in providing service and consultation to their clients, they’re required to comply with due diligence standards — or because of their legal duties and responsibilities of managing other peoples’ money. Beyond the group of people who get paid to read financial reports, does anyone read footnotes?
For a company you’ve invested in (or are considering investing in), you should do a quick read-through of the footnotes and identify the ones that seem to have the most significance. Generally, the most important footnotes are those dealing with the following:
- Stock options awarded by the business to its executives: The additional stock shares issued under stock options dilute (thin out) the earnings per share of the business, which in turn puts downside pressure on the market value of its stock shares, assuming everything else remains the same.
- Pending lawsuits, litigation, and investigations by government agencies: These intrusions into the normal affairs of the business can have enormous consequences.
- Employee retirement and other post-retirement benefit plans: Your concerns here should be whether these future obligations of the business are seriously underfunded. This particular footnote is one of the most complex pieces of communication you’ll ever encounter. Good luck.
- Debt problems: It’s not unusual for companies to get into problems with their debt. Debt contracts with lenders can be very complex and are financial straitjackets in some ways. A business may fall behind in making interest and principal payments on one or more of its debts, which triggers provisions in the debt contracts that give its lenders various options to protect their rights. Some debt problems are normal, but in certain cases, lenders can threaten drastic action against a business, which should be discussed in its footnotes.
- Segment information for the business: Public businesses have to report information for the major segments of the organization — sales and operating profit by territories or product lines. This gives a better glimpse of the parts making up the whole business. (Segment information may be reported elsewhere in an annual financial report than in the footnotes, or you may have to go to the SEC filings of the business to find this information.)
Stay alert for other critical matters that a business may disclose in its footnotes. Scan each and every footnote for potentially important information. Finding a footnote that discusses a major lawsuit against the business, for example, may make the stock too risky for your stock portfolio.