This article is from the How to Start an Investment Program tutorial, author unknown.
When you receive an annual report, the first things you will notice are the glossy pages, full color photos of smiling executives and happy workers, and lots of pie graphs and bar charts. Admittedly, the company marketing department has tried to project a favorable light with the publication in order to attract potential investors, so accept their efforts for what they are.
The first important piece to peruse is the chief executive's report. Here you will usually find his/her rationale as to why the company did better than expected, worse than expected, or about the same as before. If the company had a good year, the executive's statement will typically be somewhat self-congratulatory. On the other hand, if the company had a bad year, the chief should briefly, and convincingly, explain what management plans to do to get the company moving again in the right direction. If you have access to the previous year's annual reports, you can determine for yourself if the chief has lived up to earlier promises in turnaround situations.
In the back of the Annual Report is the Consolidated Balance Sheet, typically printed on cheaper paper. This is where you will find information to help you evaluate a company's financial position. Included here will be the current assets and current liabilities of the company, along with the income statement and the cash flow statement.
One of the more common uses of the data found is in making comparisons by ratio analysis. Liquidity ratios, for example, are useful in determining if a company has the ability to pay its debts. Dividing the company's current assets by it's current liabilities, called the Current Ratio, can indicate if a company is getting into financial difficulty. If the industry average for this ratio is 2 to 1, and the company you are investigating has a 1.5 to 1 ratio, you should probe deeper. Trouble may be on the way.
The income statement is another source for useful ratio analysis. By dividing the net income by the sales, you can determine the company's profit margin. If the margin is below industry standards, it may mean that the company needs to trim its cost to be competitive. Or, it may mean the company is reporting sales before the money is actually received. These two are just a few examples of ratios that you can use to track a company's performance.