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5 Things You Should Know About Financial Statement Footnotes

Jul. 28, 2013 3:39 PM ET
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Seeking Alpha Analyst Since 2011

Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for www.TheStreet.com and the StockCharts.com Top Advisor Corner 

Financial statements are supposed to be straightforward summaries of what actually took place in a corporation, understandable by all. Right?

Not quite. The balance sheet (summary of assets and liabilities on the last day of the quarter or year), income statement (activity during the period ending up with net profit or loss) and a summary of cash flow (money in, money out) are only summaries of the numbers. Much more detail is found (or hidden) in the footnotes to these statements.

It sounds easy enough. Footnotes provide more details than just the numbers. They explain the accounting assumptions going into the report, and they list anything not immediately found in the list of accounts. But the footnotes are also highly technical and difficult to understand unless you have an accounting degree. For many corporations, footnotes run for many pages. The 2009 annual report for IBM, for example, includes 56 pages of detailed notes. Some simply expand on the financial statements; others are very technical and hard to understand.

What can you gain from the footnotes? With the vague and complex accounting rules behind financial statement preparation, it is difficult to know if you're getting a reliable picture of a company's performance just from the well-known summaries. So what guidelines should you rely on for better understanding these important disclosures?

A few guidelines:

1. If it doesn't make sense, ask. As a stockholder in a publicly traded company you are entitled to explanations. Call or write to the stockholder relations department and ask for further explanation if a note doesn't make sense.

2. Rely on long-term trends and not just one year. In financial analysis, the most important thing is what is taking place over many years. Check five or even 10 years worth of results to size up a company and its financial strength, earnings and competitive abilities.

3. Identify a few important notes and focus on those. Everyone favors different kinds of analysis. For example, if you are especially interested in how a company manages its cash flow, read the notes on long-term debt policies and plans.

4. Look beyond the financial statements. Rely on analysis by companies like Standard & Poor's. Read the stock reports offered free of charge by many online brokers. This is an excellent source of analysis of a company, and the reports provide 10 years of results. S&P also compares reported net income with core net income (income from the company's main product or service, excluding one-time or unrelated sources of profits).

5. If something does not sound right, trust your instincts. People want to trust "authoritative" reports, including annual reports and financial statements. That trust is not always deserved. Read the letter from the Chairman appearing in the front of the annual report. Does it sound sincere, or more like a lot of smoke? At times, it is difficult to tell what is really going on because that smoke obscures your view.

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