What Is a 10-K and Why Should an Investor Read It explained by professional Forex trading experts the “ForexSQ” FX trading team.
What Is a 10-K and Why Should an Investor Read It?
Understanding a 10-K and Its Importance in Investing
The Form 10-K is an annual filing that publicly traded companies are legally required to send to the Securities and Exchange Commission. The Form 10-K contains almost everything about the business that an investor would want to know before buying or selling shares of stock in the corporation or investing in the firm’s corporate bonds. These documents are available to the public for free and can be accessed physically in Washington, D.C.
or downloaded online from innumerable websites, often including the company itself, which wants to make them easily available for existing and potential investors.
The best way to think about a Form 10-K is to consider it a document that the government forces management to prepare for you, the owner/potential owner, explaining the company’s finances, risks, opportunities, and current operations. It is full of the nitty-gritty details that make a lot of people’s eyes glaze over. Unfortunately, there is no way to simplify it. Once you’ve read a few 10-K filings, they will begin to look more and more accessible because they typically follow the same pattern.
Items an Investor Might Find in a Form 10-K Filing
Because the government requires certain information to be included in the Form 10-K, no matter which company’s 10-K you read through, you’ll find they contain many of the same items. Let’s look at a few of them so you can feel more comfortable before you try and tackle your first SEC filing.
- A Form 10-K filing will include 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 1990s was a mutual fund companycalled Janus that began as a tiny subsidiary of a railroad in Kansas City. Shareholders who read through the railroad’s Form 10-K and found that this little money management unit was doing spectacularly made enough money to retire in just a few short years.
- A Form 10-K filing will provide disclosures of risks the company faces, including current lawsuits. Throughout my career, I’ve actually come across companies that otherwise looked very healthy, but after a reading through their risk disclosures, they were facing the spectre of bankruptcy due to pending lawsuits that threatened to take down the entire firm. Famous cases include the asbestos trials decades ago when businesses that were only tertiarily related to construction were sued and forced into liquidation or reorganization, wiping out the business and its stockholders. The risk disclosures is not a section you’ll want to lightly skim through. In fact, you’ll definitely want to set time aside to read through them and understand them in depth. Current accounting rules are written in a way that if management cannot accurately predict the potential damage of a certain risk, it may not have to put aside any reserve at all so the exposure doesn’t show up in the financial statements.
- A Form 10-K filing will include 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 Form 10-K filing because, together, they allow you to see what is going on with a 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 10-K. 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, you’ll find in-depth articles and analyses to help you make sense of these important financial statements.
- A Form 10-K filing will list aggregate operating leases that don’t count as debt on the balance sheet but are real obligations nonetheless. There are many forms of debt that can make a company go bankrupt that do not show up on the balance sheetdue to accounting rules but the law requires the payments be disclosed in the Form 10-K filing. To help you understand this concept better, imagine that you owned a small clothing boutique at the local mall and had no debt. You signed a lease to the mall owner that requires a monthly rent charge of $10,000. 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 on your balance sheet, but if revenuesdecline and you stop sending checks to the landlord, the mall owner can kick you out of your storefront and force your company into bankruptcy due to the missed lease payment. These obligations are disclosed somewhere in the Form 10-K, often under a section called “operating leases”, “fixed payments”, or “minimum cash payments due”. Find it. Read it. Know it.
- A Form 10-K filing includes a look under the hood at a company’s accounting policies and practices. Imagine that you are considering buying stock in a washing machine manufacturer. Suddenly, the company makes national headline news because thousands of models are breaking down beyond repair. Is the company on the hook for taking them back from customers? In the Form 10-K filing, a company must disclose its warranty policies and estimated warranty costs for products it sells or manufactures.
- A Form 10-K filing includes signed letters from the CEO and CFO swearing under oath that 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 Form 10-K or other required disclosures.
- A Form 10-K filing includes a letter from the company’s independent auditor. This letter should detail the scope of their certification of the financial records, as well as any material deficiencies it uncovered. If the auditor thinks the company could face immenent demise, you might see the auditor reference a question as to the company’s ability to “continue as a going concern” or some derivation thereof. If you ever come across those words, or a similar phrase, alarm bells should be ringing.
You’ll Notice Certain Patterns In Form 10-K Filings by Industry and Sector
As you develop your own circle of competence around certain industries and sectors, you’ll notice specific things that are unique in the 10-K filings of the firms you are analyzing.
For example, if you are investing in bank stocks, you’ll realize that it’s common to find page after page of information in the Form 10-K filing on the financial institution’s book of loans detailing the geographic breakdown of the money it has loaned to customers, the type (residential mortgage, small business, real estate development, automobile, student loan, etc.) of loans it has made, the weighted average interest income it’s generating on those loans, the non-performance and default experience it is having with those loans, and the reserves it is putting aside from income to cushion against future problems with those loans.
Using 10-K Forms in Your Investment Analysis
In a nutshell, the bullet points listed above are the important parts of a 10-K. Learning to read one is sort of like swimming. At some point, you have to jump in the pool and get wet. You don’t need to start doing Olympic-quality dives right away or swimming faster than Michael Phelps, so feel no pressure to get into sections dealing with things like advanced pension accounting immediately. Instead, just flip through the pages and read what you do understand. Keep doing this, building on your knowledge brick by brick. 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 can learn this, and you will learn this if you are willing to put in the work.
A Form 10-Q filing is a smaller version of the Form 10-K filing. The Form 10-Q filing is filed at the end of each business quarter with the SEC. To learn more, check out my financial statement guide for new investors.
What Is a 10-K and Why Should an Investor Read It Conclusion
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